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When and why to sell a stock short; rules and strategies (Pt 1)

Xray short sellling vision

Many investors have heard of the concept of short selling and perhaps many of those people are familiar with the rules of short selling and the strategies behind doing it.

It is intrinsically a very risky move as you are betting against the upward trend of the stock market in the hopes that a stock will go down in price but when used strategically with other long positions or on a case by case basis, it can be very profitable.

When I think of describing the concept of short selling, I almost think of it as the opposite of investing because you believe a company’s stock price will rise. That is, you believe the stock price of a company is overvalued and that it will drop when the market corrects.

Thus, the seller is selling high and then buying low. The profit will be the difference between the price you eventually buy the shares for and the (higher) price you sold them for (minus brokerage fees).

The problem however, is that when value investing in a stock, you can hold the stock forever waiting for it to increase and your losses are limited to the capital you contributed whilst when you are short selling, your losses are not limited and waiting longer time frames become very risky and costly.

Edit 22 September 08 – Short selling no longer possible on the ASX.

Short selling stock procedure

Short sales are orders to sell securities that the seller does not own. It order to do this, a seller must follow the short-sale procedure below:

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