Spending time trading and investing is a fantastic way to build your wealth. But with so much new terminology to get your head around, knowing what is what can be confusing!
We have put together this quick guide to take you through everything you need to know about betting against a stock. Keep reading to embark on your next step of being a money whiz!
What Is Betting Against A Stock?
Betting against a stock is the term given to a specific type of short selling. When you bet against a stock, you are basically betting that you will be able to buy the stock back after a price drop.
How Does Betting Against A Stock Work?
Betting against a stock works like this:
- Borrow stock from your broker. The price you pay to have a loan of this stock will vary depending on the market, and what stock you are borrowing.
- Sell the borrowed stock immediately and at the – hopefully high – market price.
- Now you need to sit back and wait for a while.
- When the price of the stock has dropped, buy it back.
- Return the borrowed stock to your broker.
Because you bought back the stock for less than your selling price, you have made some money. Work out your final profit by subtracting the buying price, the borrowing price, and any other associated costs from the selling price.
Short Selling
We have already mentioned that making a profit by betting against a stock is a form of short selling. Here is a more detailed overview of the process, as well as some other considerations for you to keep in mind.
- Getting hold of shares or stock to borrow: keep in mind that, because you don’t own these shares you are just borrowing them, you can only conduct margin trading. This means that you have to put up a margin as collateral against your buying and selling transaction.
- Selling the shares: you need to sell the shares immediately. Hopefully, you are selling stock at a higher rate than what you will pay by buying them back. If you don’t you will not make a profit and could lose money.
- Buying the shares: you may need to wait a while for the share price to drop enough for you to make a handsome profit. Buying back borrowed shares that you have sold is called buy to cover.
One thing to bear in mind is your potential impact on the market. Whenever anyone buys to cover – a necessary step in short selling – the price of the stock will be driven up when short sellers close trades.
This is part of the reason why market trends are never straight lines – there is always a little variation to create a wavy line if plotted on a graph.
Market Pattern Explained
If you were to study a series of market graphs, you will quickly notice that the whole market scene is very complex and interwoven!
Whenever there is the start of a downtrend, any sensible short trader – someone who is betting against a stock – will sell their borrowed shares.
They will sell to an optimistic or bullish trader who wants to acquire shares to keep the price increasing.
Once the market downtrend is well established, many short sellers will keep selling in order to keep the price falling. Eventually, the price will have fallen enough that the short seller can buy them back significantly more cheaply than their original selling price.
It is not uncommon for a short seller to buy back stock from the bullish trader they sold to.
This cycle of getting the most from a fluctuating market can continue until the downward trend reverses.
Eventually, the market will hit an uptrend simply because of the more optimistic buying and selling practices of bull traders!
Are There Benefits Of Betting Against Stock?
The process of betting against a stock reads as quite complicated and can be fraught with difficulties – so why do people do it? In short, it is a relatively secure way of turning a profit.
Because a short seller – someone who bets against a stock – can make a profit when there is a market uptrend or, crucially, a downtrend, you can make a profit no matter the state of the market.
Another benefit of short selling is that it is open to traders with limited or minimal capital.
This makes it a great starting point for beginners with a smaller trading portfolio for more established traders to try something different.
Remember – just because you can trade big doesn’t mean that this is the only way to trade!
Are There Risks To Betting Against Stock?
As with anything, there are some disadvantages to betting against a stock.
First of all, there isn’t really a limit on how much money you can lose short selling.
You could find yourself in a situation where the price of your borrowed stock keeps on climbing and climbing after you have sold it. In this instance, you are going to lose money.
Selling short can also be halted. This is usually done for massive exchanges that trigger circuit breakers that are designed to prevent a huge crash in prices.
While this can be inconvenient for a short seller, on the whole, this process is a good thing! It will stop panic sell-offs, thus creating a more stable trading environment.
Can I Bet Against The Stock Market?
So, now you understand how betting against a stock and short selling works, you may be wondering how you can bet against the stock market in order to turn a profit.
In the US, there are several institutions and financial instruments that make it possible to short sell a surprisingly large chunk of the US stock market.
Because of this, you may want to rethink your strategy when it comes to selling large groups of stock over smaller ones.
We recommend that you shift your mindset to questioning which assets you want to short sell as this will help you keep control of your portfolio.
Final Thoughts
Betting against a stock or short selling is the process of selling the borrowed stock for more than you plan on spending buying it back.
This style of trading is called selling short and is a good way for trading newbies to get involved as you do not need a massive backdrop of capital to get started.
Keep in mind that you won’t keep the stock that you sell and buy back – you will need to return it to the broker you borrowed from and usually pay them a fee or other associated costs.
However, the money outside of these fees that you make selling and then buying back cheaply is yours.
That said, this method is by no means foolproof! There is no limit to what the price of stock or shares could rise to after you have sold them.
If there is an increase in price rather than a decrease, you will lose money.
