Advanced Short-Term Stock Trading
There are a number of ways that some experienced investors seek increased returns by taking on more risk.
Buying on Margin
When you buy stocks on margin, you borrow part of the cost of the investment from your broker, in the hopes of increasing your potential returns. To use this approach, you set up what's known as a margin account, which typically requires you to deposit cash or qualified investments worth at least $2,000. Then when you invest, you borrow up to half the cost of the stock from your broker and you pay for the rest. In this way, you can buy and sell more stock than you could without borrowing, which is a way to leverage your investment.
If the price goes up and you sell the stock, you pay your broker back, plus interest, and you get to keep the profits. However, if the price drops, you may have to wait to sell the stock at the price you want, and in the meantime, you're paying interest on the amount you've borrowed. If the price drops far enough, your broker will require you to add money or securities to your margin account to bring it up to the required level. The required level is based on the ratio of your cash and qualified investments to the amount you borrowed from your broker in your account. If you can't add enough money, your broker can sell off the investments in that account to repay what you've borrowed, which invariably means that you'll lose money on the deal.
Short selling is a way to profit from a price drop in a company's stock. However, it involves more risk than just buying a stock, which is sometimes described as having a long position, or owning the stock long. To sell a stock short, you borrow shares from your broker and sell them at their current market price. If that price falls, as you expect it to, you buy an equal number of shares at a new, lower price to return to your broker. If the price has dropped enough to offset transaction fees and the interest you paid on the borrowed shares, you may pocket a profit. This is a risky strategy, however, because you must still re-buy the shares and return them to your broker. If you must re-buy the shares at a price that's the same as or higher than the price at which you sold the borrowed shares, after accounting for transaction costs and interest, you will lose money.
Because short selling is in essence the sale of stocks you don't own, there are strict margin requirements associated with this strategy, and you must set up a margin account to conduct these transactions. The margin money is used as collateral for the short sale, helping to insure that the borrowed shares will be returned to the lender down the road.