Short selling or shorting is a trading strategy that refers to selling borrowed stocks or other investment instruments.
Traders look for quick gains when they anticipate a price fall in any of the asset’s prices. It requires a margin account and trades are placed using leverage offered by the brokers.
Let us discuss what is short selling and how it works.
What Does Short Selling Mean?
Short selling is a trading strategy that involves selling borrowed securities and buying them at lower prices.
It involves devising the trading strategy in anticipation of falling the prices of the financial securities. It is contrary to conventional trading where traders hope for a rise in the prices of financial securities.
Short selling is an advanced trading strategy that requires expertise and skills in trading. It is a risky trading strategy that is suitable for experts only.
Short selling is often considered only for speculation when traders make profits. However, it can be devised for hedging risks in a bearish market as well.
How Does Short-Selling Work?
Short selling seems like a simple plan to first buy borrowed stock and immediately sell them and hopes the prices will fall. If they do, the trader will buy them at a lower price and return them to the broker.
However, the shorting requires more than planning the trade only.
Here are a few steps to know about short-selling.
The first step is to open a trading account with your preferred broker. Most online brokers allow short selling and allow margin accounts.
Margin account requirements may vary by the broker account. For shorting, the margin requirement will be at least 50% of the total short-selling trade value.
You can use the margin in your account to buy your preferred stocks or securities. You wouldn’t be able to liquidate that cash though.
You can set the stop order position and enter a short position.
You can keep the short position open as long as you want. However, you’ll pay interest, commission, and trading costs on the borrowed money in your margin account.
You’ll close the short position if the prices of your sold securities fall. You’ll then buy them back at lower prices and return them to the broker and keep the profits.
When to Consider Short Selling?
Knowing how to devise a short strategy is important but you must consider the ideal conditions for shorting as well.
A broader indicator is the bearish trend in the market overall. In a bearish market, stocks will decrease generally. So, you can find an ideal stock or financial security for shorting.
Traders must use different technical indicators to confirm bearish trends. These trends should broadly indicate the bearish trends rather than for a single stock.
In other situations, a company’s fundamental indicators may deteriorate and the stock prices may start falling. Traders can utilize these trends as well.
Other positions where traders may opt for shorting are when stock prices are elevated to a saturated point. The stock prices would eventually start declining and open opportunities for short selling.
Example
Suppose you want to invest in ABC company’s stock for shorting. It is currently trading at $50 and you anticipate it would decline in the next few months.
You can set the short trade with a stop loss at $50 and execution at $45. You buy 500 shares of ABC company with your margin account.
Suppose your analysis was right and the ABC stock falls to $45 and execute the trade. Your gross profit is $2,500 on the trade.
Your interest charges for the borrowing period plus the trade commission will be deducted from the gross profit.
The same trade could have ended as a loss if the ABC stock price increased above $50. However, if keep holding the stocks, you’ll incur more interest costs as well.
Short Selling for Speculation
Shorting can be performed for speculation and hedging. Speculators want to take advantage of market inefficiencies and want to earn a profit when they see a bearish trend in a stock or index.
Speculative shorting requires active trading strategies and a short time horizon. Speculators would find securities to short sell within a short time.
This strategy is highly risky as the traders would have to buy stocks/assets at higher prices than they purchased them for.
Long-term investors may also look for shorting with speculations about a particular stock or asset. However, their approach and research are different from traders looking for quick gains.
Short Selling for Hedging
Traders can use shorting for hedging purposes as well. It can be used to limit the downside risks of decreasing the prices of a stock or asset.
For example, if you hold a call option which is a long position, you can short sell the same stock for limiting the risks of decreasing the price of the stock.
Arranging a hedge through shorting can be done for limiting losses as well as lock in profits with earlier trades.
Both these strategies for short selling require intensive research and careful consideration though.
Cost of Short Selling
The total cost of short selling includes margin interest, borrowing stocks, and the opportunity cost of paying dividends on the borrowed stocks.
The margin interest is the interest cost on the borrowed stock as shorting is possible through margin accounts usually.
If you hold the short position overnight, you incur interest costs. Although traders keep the short-selling position open for a short period, they incur interest expenses.
Another significant cost may arise as borrowing fees on some stocks that are usually unavailable in the market for borrowing. Brokers typically charge a high lending fee for shorting stocks.
If the stocks are difficult to borrow, the brokers would charge a significant fee. It can be a major factor when devising the shorting strategy.
During the borrowed stock period, the company may announce dividends. The trader of the short-selling would return any dividend payments to the lender as well.
Other trading costs such as trading commission and account transfer fees are included in the total cost of shorting as usual.
Risks of Short Selling
Shorting is a risky strategy and traders should consider these risks.
Short selling may be banned by regulators in some sectors or markets broadly to avoid panic and speculations. So, short selling is not feasible for everyone in every market.
This strategy also requires using a margin account. You must maintain a minimum margin when investing in a short trade.
If the stock prices change, you may get a margin call and need to fund the margin account. Typically, brokers would require maintaining a minimum of 25% of the total trade amount.
If more traders start speculating about a certain stock, it may lead to short squeezing. short squeezing means when traders start covering their short trades by buying back the stocks again.
Another important consideration is that traders would bet against the trends. Generally, the share prices increase over the long run. Whereas short trading requires speculating stocks to fall in price.
It means speculators go against the general trend of stock price appreciation.
Advantages of Short Selling
Short selling has several advantages for speculators and traders looking for short-term.
- It can be used for speculations and hedging by investors.
- It can be used with leverage requiring low initial capital investment.
- Shorting can help investors maximize profits when moving against the trends.
- Shorting helps in protecting portfolio returns by hedging the investment risks.
Broadly, short selling helps the market overall in a broader way as well. Some experts say that shorting helps in bringing out the facts and news about companies that conventional trading wouldn’t highlight.
Speculators and traders of short selling rely on negative news and triggers about stocks. These events would have no value in the market if not for short selling.
Disadvantages of Short Selling
Shorting comes with some drawbacks as well.
- Short trading is harder as you move against the general upwards stock trends.
- The potential losses with shorting are unlimited as the stock prices may rise indefinitely.
- You need a margin account to place these orders.
- You need to maintain a margin in your margin account and may get a margin call.
- The total cost of a short trade may rise significantly with the trading commission, interest, and fund transfer costs.
- Finding sufficient stocks to close the position can be difficult at times as well. If the required stocks are unavailable, then you may need to pay a premium fee to acquire these stocks.
