Short selling or shorting of stocks means trading borrowed shares. Traders make transactions of stocks or other securities they do not own in the first place. They use margin accounts that provide them leverage to buy shares without investing the full amount required.
Traders and speculators do short selling for making profits. Investors and institutes often short sell securities to hedge against financial risks.
What is Short Selling?
The traders borrow shares from a broker, sell them at a market price, and buy them back at a lower price to return to their broker. Margin trading allows traders to perform such transactions with minimum initial margin investment.
Short selling works on speculation of stock prices falling in the future. As the traders do not pay upfront for buying the stocks, they sell them to other investors at market price and look to payback in shares to their brokers.
Short selling is a high-risk trading strategy. The prices of the borrowed stock may go upwards against the speculation of the trader. Even if the prices do not rise, the trader cannot make substantial gains unless the stock prices fall.
To open a short-selling position, traders use margin accounts. They use leverage to buy a large number of stocks in anticipation of a price fall in the future. The speculations are usually for short periods, a few days or months at most.
To close a short-selling position, the traders must buy the stocks from the market. The difference in the borrowed stock price, sold at market price first, and then bought back at a lower price is the profit for the traders.
Example
Let’s say a trader speculates a fall in quarterly income of a company ABC in 1 months’ time. The trader borrows 500 shares of ABC priced at $ 50. The trader shorts the borrowed 500 stocks at $50. After 1 month, the company’s quarterly revenues are announced. If the trader speculated correctly, the lower revenues would cause a fall in the stocks, say to $40. The trader would buy those stocks at $40 to give back to the broker with whom it opened a margin account. The trader makes a profits of $5,000 ($50 -$40= $ 10 * 500) less commission and taxes.
Margin and Short Selling
In the practical world, traders bet on tiny movements in share prices. Making profits with the smallest of fractions requires substantial investments. The risks with such large scale investments are too high. Regular traders, arbitrageurs, and speculators lack access to large pool investments. They use the leverage of margins offered by brokers and other financial institutes looking to make commissions.
Margin accounts incur high-interest costs and require minimum margins to maintain. The traders may receive margin calls if their balance falls below the minimum margins. Shorting requires speculations for short period, yet it is a costly practice.
How to Make Money with Short Selling
Short selling is going against the tide of market sentiments. Stock markets perform upwards largely. They do show falls every now and then, otherwise, the stock markets wouldn’t balance. The traders speculate a fall in certain company’s shares to make profits.
When should a trader look for short-selling?
- Stock is priced too high that it elevates to the overvalued mark, the fall in price becomes inevitable. Some companies do a stock split at that stage.
- A trader believes a certain stock is temporarily overvalued by optimistic investors.
- Fundamental analyses indicate a future drop in stock performance.
- Any company’s macroeconomic effects such as a drop in sales due to political tensions, litigation, etc.
- Technical indicators showing lower performance indicators such as average prices or stock trading volumes.
- A bearish stock market condition, where shorting is profitable usually.
Short Selling As Hedge Instrument
Long-term investors do no perform shorting. Sometimes they do have to perform shorting to hedge against losses. Financial institutes also involve in shorting sometimes to hedge against losses due to unfavorable movements in currency pairs or stock prices.
Hedging practice with short-selling also carries the same risks. If the prices move downwards the investors mitigate their losses in invested shares. Conversely, if the stock prices move up, they lose on shorting. The investors also lose on the opportunity cost of making profits, since they had invested as long position earlier.
Advantages of Short Selling
Although making quick gains with shorting is the biggest motivation, it offers certain other benefits to the traders as well.
- Traders can use short selling as an effective hedging tool against stocks, currency movements, or industry risks.
- Short selling uses margin accounts, which requires low initial investments upfront.
- The high-risk shorting strategy brings high profits for traders too.
- Short selling provides more trading opportunities that increase the number of transactions, hence keeps the liquidity of stocks.
- Short selling ratifies the overvalued and optimistically elevated stocks.
Speculators and traders indulged in short selling argue in favor of the practice as the core activity of the stock market. It keeps the stock markets in check.
Risks with Short Selling
Short selling is a high-risk trading strategy. The traders can lose money in many ways. It affects individual traders as well as other parties involved in the trade as well. Short selling performed simultaneously can cause stock market dysfunctions as well.
There are several risks a trader must consider before short-selling strategy.
- Traders require to open a margin account with brokers, which is expensive and requires initial investments.
- The brokers charge high-interest costs on margin utilization.
- Traders require a minimum balance in margin accounts called the maintenance margin.
- The overvalued stocks may ratify the prices before the traders close their short position.
- Any dividend, stock split, or share buyback announcements from the company can severely affect the shorting strategy.
- Traders may not find enough stocks to close the shorting position.
Traders can also face regulatory risks if competent authorities find any manipulation in practice. The regulatory authorities can temporarily ban the short-selling activities for a certain company as well.
The risks with short-selling are high. It yields high profits for traders and great losses as well. Traditionally, stocks appraise at prices even without high-performance indicators due to inflation adjustments. Modern traders use sophisticated technical indicator tools to make profits with shorting.
Conclusion
Short-selling is making profits with borrowed stocks on leverage. The traders bet against the market sentiment to speculate a fall in the share prices. Shorting is a high-risk and high-profit strategy. It can be used as a profit-making and hedging tool.
