Reason to Short Sell a Stock
Short selling means selling a stock you don't own in the hope that the price will decline and you can repurchase the stock shares at a lower price. The difference between the higher price you originally sold the shares for and the lower price you paid to repurchase them is your profit. To execute a short sale, you borrow the shares from a brokerage firm. When you repurchase the shares later on, you return the shares you borrowed to the brokerage firm's account.
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Fundamental Analysis Reveals Problems
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Investors sell stocks short because they believe the company faces potential problems that could negatively affect revenues, earnings and eventually the stock price. The investor may decide that statements made by company management about the positive future outlook for the company are not realistic. The rate of growth of sales year over year may be slowing. The company might be profitable, but profit margin as a percentage of sales could be declining. An investor may carefully review the company's financial statements and question whether the accounting methods used presented a truly accurate picture of the company's financial health.
Competitive Threats
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Investors track the performance of a company's competitors in an effort to gauge whether the company is losing its competitive advantage. A competitor might be about to introduce a new product line that will draw customers away from the company, or force the company to lower prices in order to compete, which would have a negative effect on gross margins. A company that is losing market share may also see a decline in investors' enthusiasm for its stock, and the price will drop.
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Potential Financial Setbacks
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A company may be involved in current or potential litigation that could turn out to be costly. Pharmaceutical companies, for example, are from time to time subject to lawsuits due to alleged harm caused to patients who took a drug the company manufactures. Whether or not the lawsuits have merit, the threat of litigation can cast a cloud over the company that causes the stock price to at least temporarily decline.
Loss of Confidence in Company Management
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Conflict over the strategic direction of a company can cause top executives to leave or be fired. Key contributors to the company's success may be hired away by a competitor, such as members of the company's research and development team. Investors may also spot poor decisions made by management that will eventually cause the company to lose money, such as committing resources to entering a new market that turns out to be not nearly as lucrative as hoped. If investors conclude the management team is not leading the company in the right direction, they may elect to sell the company's shares short.
Additional Risk of Short Selling
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Financial advisers do not recommend that beginning investors get involved with short selling. The reason is risk. When you buy 20 shares of a stock for $10 per share, the maximum amount you can lose is $200, and even then, the risk of that is low if you purchase high-quality securities that have a large trading volume each day. With short selling, you sell the stock at $10 per share in the hope you can buy it back at say $5 per share. But if you are wrong and the stock continues to rise to $30 per share, your potential loss is $400 -- twice the potential loss in the first example.
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References
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