Another technique used by some experienced investors and allowed by some brokers is short selling.
Short selling is selling a stock you don't own with the aim of making a profit from a fall by buying it back at a lower price. This sounds nonsensical. The trick is achieved because your broker will lend you the appropriate amount of stock to cover the sale, possibly from another client who holds the stock on a long-term basis. The lender must have agreed to his stock being used in this way, and may call for its return at any time.
In other words the steps in the process of short selling are as follows:
This sounds all well and good. It is simply a way of profiting from spotting a stock that is overvalued; in much the same way you might buy a stock that looks cheap.
There are some big drawbacks to doing it.
One is that the price of the stock might go up. If so, you will be forced to buy it back at a higher price i.e. a loss. The broker may require you to return the stock before you are ready to do so (because the holder wishes to sell it), perhaps forcing you to buy it back at a loss. And you won't earn interest on the proceeds of your short sale.
You will need to have a margin account with your broker before being able to sell short, in order to have collateral available to guarantee any losses you might incur.
The risk that the market might rise while you are short can be neutralised by buying a similar stock you think is cheap at the same time as you make the short sale. It might for example be a stock in the same industry. In the UK context, for example, you might short BT and buy Vodafone (or vice versa, depending on your view). In theory, you should profit from the overvalued stock getting cheaper and cheap stock increasing in value. This is known as a 'pairs trade'.
You should only contemplate short selling if you are an experienced investor and have a high tolerance of risk. Some brokers forbid it.
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