What is short selling?
Short selling or shorting or short position is a trading strategy used by anticipating a decline in the price of a stock or other securities. Having a short position in a stock means that you do not own shares of that stock. You borrow shares of the stock from your broker and sell them. You must buy the same number of shares in the same stock and return them to your broker.
Your profit will be the difference between the sale and purchase price of those shares. You only profit when the price goes down.
This technique is different than having a long position in a stock. Traders who are in a long position have complete ownership of their shares and they benefit only when the stock’s value goes up.
More on a short position
To understand how short selling works, we must go back to the beginning. There are a ton of investors in the market. Some big guys put their money in a stock for a lifetime. They don’t care when the stock moves up or down. What they care about is that they are in a position and they are in for a long time.
Because of this reason, the stock markets, brokers, and stock exchanges found a way to make extra profits from them. Since investors does not mind, brokers can let people borrow and sell those shares that are sitting in their account for years.
The catch is: you must return all shorted shares back to your broker. Technically, you sold shares of some random rich guy somewhere that you don’t even know. He will not be happy if his shares are not returned.
This is why shorting is restrictive and you need a different type of account in order to short. You must have a MARGIN account and rules are different from regular cash accounts.
Example of shorting
Let’s say that you are anticipating a downward trend in a stock XYZ. So, you decided to take a position size of 100 shares in this stock at $4 each. That is you shorted 100 shares by borrowing them from your broker and selling them at $4 each. Your total sale price will be $400.
As you anticipated, the price of XYZ stock goes down to $3.50 per share. After this decline, you decided to exit your position.
Since shares you sold in the first place were not yours, you will have to return them to your broker to end your position. You then buy all 100 shares at $3.50 per share at a total of $350.
How much money did you make or lose on this trade? Well, you sold shares at $400 and bought them back at $350. The difference between these two numbers will be your profit. That is you made $50 of profit on this trade.
Why short sell?
There are many reasons traders and investors short sell stocks and other securities. However, there are two main reasons for short selling.
- Speculation: Investors and traders speculate a downside movement of a stock. They then sell shares of the stock hoping to buy them later at a low cost. Thus, cashing the difference.
- Hedging: This is a technique used by investors to offset the downside risks of a long position they took in the stock. Investors use the same or similar security when hedging.
Benefits of short selling
Short selling offers a lot of benefits for traders. The following are a few of the many benefits of shorting.
- You can still benefit even if stock markets are going down
- Traders can maximize their profits by using shares they borrowed
- You can use the leveraging technique to acquire more shares using borrowed capital
- Access to trading a stock both ways which can increase your flexibility and returns
Disadvantages of short selling
Short selling is a very risky technique that requires a high level of experience for success. The following are some of the disadvantages of short selling.
- By default, there is no limit to how much you can lose. If the stock moves up, your loss will be determined by how high the price gets. You will keep losing as long as the stock moves up. You will have to buy all shares and return them to your broker no matter how high the price gets. You will pay for that price.
- Short selling can crash a market. If many people short stocks in anticipation of a crash, the market can bottom much lower due to short selling.
- Margin calls could be a big issue for many traders. Traders must have margin accounts and follow the margin requirements in order to short sell stocks. Once you take a position, you will need a margin maintenance percentage. This percentage can increase or decrease depending on the volatility of the stock.
Final words
Shorting is a very risky trading strategy. Although returns on a short position can be great, endless risks lurk in the shadows. This is a technique for experienced traders and investors who fully understand what they are doing.
Stay away from shorting in you are still learning how to play the game.
