The stock market allows us to speculate, based on sentiment and pertinent information, about the market value of a company and its shares. More often than not investors pick stocks based on their assumptions that the prices will increase, but also sometimes because they believe that the stock will lose value, a much riskier venture.
To purchase stocks that you believe will increase and therefore grow your initial investment, is to have a long position. Certainly there is downside, but the downside is capped at zero (you can only lose as much value as the stock presently has), whereas the upside is exponential.
To choose stocks that you believe will decrease in value, is to have a short position. This investing strategy is a little more complicated than going long and should typically only be performed by experienced investors who can stand significant losses. The risk with shorting, is the inverse of going long: the downside is exponential.
For example: if I hear that Company A is having management issues and I’ve recently read that they are also losing distribution and sales are declining, then I might assume that the stock will lose value. I see this as an investment opportunity to make money (though frankly it’s kind of a jerk position to take because you now want the company to fail which ultimately really hurts its employees and the local economy around the business), and so I bet that the shares will decline from their current value of $20.00 each. To do this, instead of buying stock, I borrow the number of shares I want, say 100, and then sell them in the market. I am now “short” 100 shares, and have $2000.00. In order to close the loop on this transaction, I will have to purchase the shares out of the market (when I see fit), and this purchase is where my gains or losses are determined. Essentially I am hoping the shares plummet, but I’m not too greedy, so when I see the shares hit $10, I decide to purchase the 100 shares for $1000 and realize a nice $1000 profit. If I was greedy and decided to further wait, but then oh no, all of a sudden the company is acquired or starts better performing and the shares gain in value and they hit $40 each, I essentially become screwed. Better sell before they increase any further. So I purchase my 100 shares from the market for $40 each and realize a $2000 loss. The risk with shorting, is that the risk is exponential as the shares can rise to an infinite value.
Feature image via thechoicelife.tumblr.com
