The fundamental idea behind shorting a stock is to predict on a stock’s downtrend movement and profit from it.
If we were to implement this strategy last year, we would have made lots of money from it as the global market plummeted from the fear of rising inflation and interest rates. Surely, it’s a no brainer to take a shorting strategy during a bear market.
While the intention behind shorting a stock is the exact opposite of buying a stock, the fundamental concept behind it is entirely different, and this is why beginners in the market should never try shorting a stock with the intention to build up wealth.
First, when you buy a stock, technically you own a fraction piece of the company and have the right to vote as a shareholder on the company’s major decision. You can hold it forever as you like as long as there is no takeover decision on the company that you own.
This is different from shorting a stock.
When you short, you are borrowing a stock from a broker or someone else who owns it. You cannot hold your short position forever because the end game is to purchase the stock back for delivery by closing out your short positions.
This brings to the most important point, which is you are racing against time when you short a stock because you are likely to incur margin financing interest when shorting and the interests are usually pretty high – so if you are holding your short position for a period of time, then it is going to form as part of your overall profit and loss.
At today’s rate, margin financing on short positions is in the range of 7-9%, so if the stock goes nowhere for a year, you already lose out 7-9% on your overall P&L just by doing and achieving nothing. It might work if the shares start dropping more than that, but it’s a gamble to take.
Perhaps one of the other most important things to take note when shorting a stock also is the risk reward balance, which heavily tilts against your favour.
You see – when you short a stock at $50, your best chance is to have it go down to $0, which is still a solid 100% gain (although it is quite rarely that you will a stock goes down straight to nothing). In this case, if you put in $10,000, your maximum return would be to profit a $10,000 return. However, if for some reason the stock goes up, there is no cap limit which technically means there are unlimited losses potential to it – although this can still be mitigated by a disciplined stop-loss trader.
A bear market might send the share price down quicker than a bull market does, but it is never a guarantee.
Shorting a stock in itself does represent a great challenge to the mental fortitude and discipline of an investor and it should never be taken for granted that it is easy money.
While there were very few successful people who has made fortune during a bear market, there are many who didn’t quite make it as well and it turned to bite them.
If you are an investor with a reasonable amount of timeline horizon in the market, it might pay off to just averaging down on your purchase and wait for the market to recover.
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2 thoughts on “Why It Is So Difficult to Build Wealth by Shorting a Stock?”
Congratulations! BABA share price rocketed to high heavens! Your conviction is rewarded! Great foresight!
I’m sorry to hear that your $5 prediction didn’t come to light. But keep trying, you may be right some day!
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