Investing in stocks can be a great way to increase your wealth, and it’s also a pretty easy way to get started with investing, however, it’s also easy to lose your money if you don’t know what you’re doing – particularly when you are shorting a stock.
Anyway, today I want to talk about a guy who lost a lot of money shorting a biotech stock, but first:
What is Shorting (Short Selling)
So I’ll assume that you know how you can buy shares in a company on the stock market and you make money when the stock goes up, but lose money when the stock goes down.
Well shorting is pretty much the opposite. With shorting you borrow shares from a broker and you make money when the share price goes down or lose money when the price goes up when you close out the trade and return the shares to the broker – you profit or loss is the difference in price between when you bought it and when you sold it (minus any brokerage costs).
If you are sure a stocks share price is going to go lower in the coming days and you want to profit from it, then shorting the stock is the way to go. This is something that has become a lot more common place in the last decade or so and is a great way to make money when the market is in retreat, but it comes with risks…
Why is it so Dangerous?
When you are buying a stock the worst thing that can happen to you is that you lose all your money. Let’s say you buy 1,000 shares at $1 (you spent $1,000) – the most you can lose is $1,000 if the price goes to $0.00. If the share price goes to $10 though, you have made $9,000 profit.
This is why I love shares as an investment – your losses are capped to whatever you spend, but your potential gains are limitless.
Shorting a stock is a bit more dangerous, as you are “betting” that the share price is going to go down, but if it doesn’t, you can end up owing losing more than you initial investment (depending on your broker) – significantly more.
Someone had a pretty bad day, this picture describes it better than I ever could.
The trader started the day with $33,051 in his account, but by the end of the day managed to owe his broker $106,445. He lost a whopping $144,000 in one day when a stock went from $1-$2 all the way up to $16.
How to Prevent This
You could stick to buying stocks and never short them, or you could be smart and ensure that you put stop losses on any of your trades (long or short) so that if things get out of hand, you don’t lose more than you are comfortable with, and you certainly don’t owe your broker money.