Attempting to Capture Profits on a Decrease in Share Price:
Short Selling involves a trader borrowing shares of a particular stock from a broker in the hopes that the price will go down. Once the security drops to a level where the trader wants to take profits, the shares are bought back to replace the borrowed ones – this event is known as “covering” your short position. Sometimes if there is high short interest in a stock, it can result in a Short Squeeze or spike in price as short sellers attempt to cover their positions at the same time.
In general, short selling is best left for knowledgeable and experienced traders as the risk is theoretically infinite. For example: In taking a long position, the worst that can happen is the trader loses their entire investment. They buy 100 shares XYZ at $5 per share for a total value of $500. Worst case scenario is that the company goes bankrupt and the trader loses $500. In taking a short position, however, the risk is higher. Let’s say the trader initiates a short on 100 shares XYZ at $5 per share. If good news hits or the stock is bought out by another company, it can jump to $20 per share. If the short seller covers at $20, that’s a loss of $1,500. Overall, the main point to keep in mind is that the farthest down a stock can go is $0, but there’s no limit to how high it can potentially run.
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