Mastering Short Selling A Comprehensive Guide

Short Selling: Profit from Market Declines

The stock market provides numerous opportunities to earn money, whether going up or down. Have you ever thought about how one can make money when prices drop? Well, the simple strategy is short selling. But is that simple? Let's first understand the concept of short selling.
Short selling is like speculating on the value of an asset in the hope that the price will drop. Simple, isn't it? No, short selling is a complicated strategy to earn money.
The first step is very important to understand which is selling. When we want to invest in shares, we buy and own them. But, in short selling, we first sell those shares that do not belong to us.

Here, the question is, why do we sell?

Selling at a high price is always a profitable business. So, if we sell an asset at the current price, we hope that the price of the particular asset will drop, and when the price drops, we buy it. It is a reverse concept where we sell an asset and then buy it. Technically, we don't own it as we first buy the asset from the broker, sell it, and keep the profit with us.

What if the price shoots up? Well, it's a loss…might be a big loss.

Short selling is profitable when you correctly predict that the price will drop. Apart from this, it is risky as it might be challenging to analyze the hike in the price of an asset. The losses are potentially unlimited. It's only your cup of tea if you are an experienced investor or trader. It's always good to understand the market and risk management strategies.
Short selling completely changes the meaning when traders and investors apply it. For a trader, it means speculation, as it involves a huge amount of risk, and for an investor, it is called hedging, as it is done to reduce the risk.

How does short selling work?

In short selling, a seller, be it a trader or an investor, buys shares from a broker. It is necessary to buy the shares as it makes no sense to sell the share that does not exist. When the price drops, the borrower buys the shares back and returns to the broker.

Who earns in the whole process?

The borrower sells the shares at a high price, and the broker charges on the trades. As it is a risky process, a trader must have a margin and pay interest on the borrowed shares. Also, the broker-dealer firms in the US, like the New York Stock Exchange and the Federal Reserve, have set a minimum amount to maintain the called maintenance margin.

Is it a good idea to short-sell?

  • You should not prefer to short-sell unless you are a professional trader or investor.
  • The important reason is the higher chance of unlimited loss. If you are not a professional trader, you may need to become more familiar with risk-reward ratios and stop-loss strategies, which can increase your chances of incurring losses.
  • Short selling requires margin, often in the form of loans with interest. This interest is payable as long as you hold the position.
  • Additionally, despite having bad fundamentals, several events can work in favor of the company, resulting in a price hike and potential losses for you.

A few Examples of Short selling of shares

These are the two examples of shorting stocks on the basis of profit and loss; check below for more details;

Short selling for a profit

Suppose you are a trader who hopes a particular company's stock will fall in the next 2 months. Currently, the stock is trading at $65. You decide to borrow 100 shares from a broker at the market price of $65 and sell them. A few days later, the political news badly impacted the company, due to which the price of the stock fell to $55. You decide to close the position and buy the shares at the market price.

Time to calculate profit. Your profit excluding commission and interest on the margin account is $1000 ($65 - $55= 10* 100 shares = $1000).

Short selling for a loss

Taking the upper example, imagine the political news positively impacted the company, which resulted in a price rise. Now, the share price is $75. You have to buy back the shares at a higher price, which results in a loss of $1000 ($65 - $75- $10* 100 = $1000).

Advantages and Disadvantages of Short Sell

Many professional traders and investors prefer short selling because it has many advantages.
It provides considerably high profits with little capital investment. Many investors use this strategy for hedging against other investments. This lowers their risk of loss.
As it provides high profits, it can also result in unlimited loss. It requires a compulsory margin for the strategy. Sometimes, the short seller can face a problem of shortages of stocks.

Which countries allow short-selling of the stock?

Since short selling is a risky affair, a handful of the country permits to sell the stocks short. This includes The U.S., Britain, France, Germany, Switzerland, Ireland, Canada.

What happens when a stock is shorted?

When a stock is shorted, it affects the price of the stock. If selling is done in huge amounts, it can gradually drop the price. When a particular stock is shorted largely, investors buy shares, and short sellers also start to buy more to cover their losses. This creates a short squeeze, and the stocks' prices even rise. Ultimately, the short seller incurs a huge loss.

How long can you short a stock?

An investor needs a specific time to hold or short the stock. Investors can hold the positions as long as they meet the margin requirement. Keeping the holding for a short time is advisable because even if the stock stays at the same price, the borrower has to pay interest, creating an unprofitable environment.

Final words

Short selling grants a huge profit to those who know the perfect strategy behind it. Many big fund management firms use this strategy to earn profit and hedge their investments. Many traders short-sell shares to increase their capital. But, there are many cases where most people lose their whole capital just by doing short-selling. Since it is a risky trade, many countries don't even prefer to legalize short-selling. It is advisable to only short-sell if you have enough money to burn.

Read Also:

  1. What is RSI indicator?

  2. Capital Adequacy Ratio

04 Oct, 2023


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