Short selling is an investment strategy in which investors borrow a stock, sell it, and then buy it back to return it to the lender. This transaction thesis is contingent upon the stock going down in value, which is very risky but can be lucrative. Some people wonder whether it’s possible across different investment accounts like 401(k).
401(k) accounts don’t support short selling. Instead, their investment options often include mutual funds or exchange-traded funds (ETFs). These options are deemed safer than individual investing. If you’re interested in short-selling, you need a margin account, which allows you to borrow money.
This article will explain what short stocks are, why you can’t use your 401(k) to short sell, how to open a margin account, and how to invest your 401(k).
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How Do Short Stocks Work?
The concept of short selling a stock is fairly simple, and the strategy’s success is based on the stock price going down in value.
When an investor shorts a stock, they borrow it, usually from a broker. The investor then sells the stock at that price. When the stock goes down in value, they buy it back and return it to the broker. If all goes well, the investor will profit from the transaction.
Here’s an example of this in action:
If an investor believes that Apple stock is overpriced at $1,000 per share, they could borrow 5 shares of the stock from their broker. They would then sell the stock in the market at that price. If the stock goes down to $500 per share, they could then repurchase the stock at the new price and pocket $2,500 (minus any commission or interest brokers may charge) after returning the stock.
Though very simple, this strategy is incredibly risky and can cause an investor to incur great losses. For this reason and due to investment regulations, 401(k) plans don’t allow it.
Below are the pros and cons of short selling:
Pros
- Can potentially give investors large returns
- You’ll keep the majority of your returns
Cons
- Losses are unlimited; you could quickly and easily lose all of your contributions
- Gains are contingent on stock decreasing in value
- Short selling can crash the market and bankrupt a company
Why You Can’t Use Your 401(k) To Short Sell?
On the surface, a 401(k) plan can appear to be just another investment account, and because it collects your pre-tax dollars, you may assume that you can invest as you wish. However, due to regulations and the typical structure of these accounts, short selling is unavailable.
401(k) Plans Have Limited Investment Options
The first reason you can’t short sell your 401(k) is that it’s not an option. Companies offering 401(k) plans will also offer different investment options managed by financial services advisory groups, such as Fidelity Investments.
The options available range from mutual funds to bonds and can be conservative to aggressive.
These investment options are limited because it costs more for employers to offer more investment options. Furthermore, offering limited options makes it safer and simpler for employees who are inexperienced in investing their money.
Regulation T Regulates Short Selling
Additionally, you can’t short sell in your 401(k) because it goes against federal regulations. Regulation T is a rule instituted by the Federal Reserve Board of the central bank. This governs the amount of credit that brokers can lend to investors.
Regulation T also mandates that for an investor to buy securities on broker credit, they must apply for a margin account and may only borrow 50% of the purchase price of a security and fund the rest in cash. It also requires 150% of the value of the short trade to be held in the margin account at the time the short is created.
These regulations work together to ensure what’s borrowed is paid back. Additionally, if you’re less likely to pay them back, the broker reserves the right to liquidate your position according to the contractual agreement.
How To Open a Margin Account?
The process of opening a margin account is simple in itself. However, the requirements can differ depending on the broker you use. The basic information usually required to open an account is information regarding your:
- Income
- Net worth
- Liquid assets
- And an occasional credit check
Because margin accounts are riskier than a traditional account, most times, you’ll be required to have existing cash or securities worth at least $2,000 available before opening one. Keep in mind that you’ll also pay interest on any margin loan you acquire.
Companies Offering the Best Rates
Here are a few of the top companies offering margin accounts with the best rates.
- M1 Finance Plus. They currently offer the best interest rates on the market, starting at only 2%. Additionally, unlike most other companies, they don’t charge management fees for their services.
- Robinhood. They’re currently offering a 2.5% interest rate via their Robinhood Gold account. This account requires you to have a minimum of $2,000 and charges a monthly fee of $5. You can also get a free 30-day trial with this account.
- Interactive Brokers. This company offers tiered margin accounts starting off at 2.6%. Their website features a list of rules and requirements for short selling with their company. Interactive Brokers is one of the world’s oldest and well-known brokers, so it’s worth looking into what they have to offer.
- Webull. They offer tiered interest rates starting at 6.99% for balances $24,999 or lower. They also require a minimum balance of $2,000 to open an account and offer both margin and cash accounts.
Tips on Investing Your 401(k)
As discussed earlier, your 401(k) plan will have limited options for investments. Most often, you won’t be able to invest in individual stock but instead in ETFs and mutual funds. Read on to learn some of the best practices to invest your 401(k) properly.
Do Your Research
When it comes to investing, you should never do so on a whim. Keep these tips in mind:
- Start by educating yourself on your options.
- If there’s a particular fund that you’re interested in investing in, start by researching it. You should learn about how it’s performed over time, its holdings and allocations, and fees. Ideally, you want to invest in low-cost funds.
Increase Your Contributions
Many employers offer an employer contribution. Make sure you scale up your contributions to get the full match. This also benefits you because the more you contribute per paycheck, the more your savings grow and the better your 401(k) can perform. You can do so by adjusting your contributions each time you receive a raise or bonus.
Take Advantage of Your Resources
The company that houses your 401(k) plan may also offer additional resources. Whether you’re an expert or novice investor, you should take this opportunity to learn. You may have access to benefits like:
- Advisors
- Calculators
- Portfolio management
- and more
The best way to get the most out of your 401(k) plan is to understand your benefits and use them to your advantage.
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Conclusion
Short selling is a risky investment strategy typically reserved for experienced investors who are very knowledgeable of the market. Because of the nature of short selling and federal regulations, it isn’t allowed in traditional 401(k) plans.
Instead, if you’re looking to short sell, you need to open a margin account with a broker. If not, there are options available to invest your 401(k) intelligently.
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