Short selling explained
Taking a short position (also: short selling or shorting a stock) involves selling a stock you don’t hold in your portfolio that you expect to decrease in value in the near future (a vice versa move compared to a long position). Instead of purchasing the stock outright, you borrow it, sell it, and put the money aside. Then, after the price has dropped, you repurchase the stock and return it to the lender, keeping the difference as profit. Typically, short-sellers borrow the assets from their broker, who may lend from their own inventory, another broker’s inventory, or from customers who have margin accounts and are willing to lend their shares. You must have a specific brokerage account that allows you to start shorting. You’ll also need to meet your broker’s initial and maintenance margin requirements. For example, suppose that your broker has a 50% initial margin requirement on shorted stocks. In this case, you’d need to have at least $5,000 in your account to open a $10,000 short position. Additionally, the short seller is responsible for making dividend payments on the shorted stock in its entirety to whom the stock has been borrowed. Generally, short selling is a bearish investment method that involves the sale of an asset that is not held by the seller but has been borrowed and then sold in the market. A trader will embark on a short sell if they foresee a stock, commodity, currency, or other financial instruments significantly moving downward in the future. Watch the video: How Short Selling Works? Beginners’ corner:
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Uses of shorting
Usually, you would short the stock because you believe a stock’s price will fall. In essence, if you sell the stock today, you’ll be able to repurchase it at a lower price later. If this strategy works, the short-seller can repurchase the stock at a lower price, return it to the original owner, and pocket the difference between the selling and buying price for a tidy profit. However, if the price goes up, the trader may be forced to close the position at a loss. Since the long-term trend of the market has traditionally moved upwards, the strategy of short selling is seen as being risky. On the other hand, there are market conditions that seasoned traders can take advantage of and turn into a profit. For example, institutional investors will often use shorting as a hedging strategy to reduce the risk for the long positions held in their portfolios. Others use short selling purely for speculation.
Selling short example (hedging strategy)
Let’s assume you are an investor in X stock. You own 300 shares at an average price of $50 per share. You are reluctant to sell, but you’re also worried about the company’s short-term prospects due to an adverse news event, a disappointing earnings report, or a looming bear market. In this case, you decide to short 300 shares of X at $50. Indeed, your long position starts losing money once the stock’s value drops below $50. However, the profits from your short sale can negate those losses. For example, let’s imagine that X drops to $45 per share before beginning to rebound. Then, at $48 per share, you decide that X is on the upturn and exit the short position to secure profits and avoid eroding the eventual gains of your long position (in which you benefit from X appreciation).
Selling short (speculation)
Let’s inspect what a short sale of X stock might go. At present, the stock is being sold for $100 per share. But, you anticipate the stock’s price to fall and short 100 shares for a total sale price of $10,000. Suppose your forecast was correct, and the share price for X drops to $70. You then proceeded to buy 100 shares to replace the ones you borrowed for $7,000. Excluding interest and any dividends that must be paid out, your profit would be $3,000 ($10,000 – $7,000 = $3,000). Conversely, let’s assume that your guess was wrong and the price of X booms to $130 per share before you finally opt to close your position. At $130 per share, you’d have to pay $13,000 to replace the 100 borrowed shares, resulting in a $3,000 loss ($10,000 – $13,000 = -$3,000).
Short selling vs. long put options
Short selling is somewhat similar in strategy to a long put options. Long put options grant the buyer the right to sell shares of stock at a preset price in the future, essentially, too, betting a stock’s share price will decline. The critical difference is that, with a long put, you don’t have to borrow outright to buy the stock upfront and hope it decreases in value before you have to reimburse it. Instead, you merely reserve the right to do so before the end of the options contract. Then, if the drop doesn’t happen, you just let the option expire.
Special considerations
Potentially limitless losses
The primary risk of short selling is that your prediction could be wrong, and the stock price may increase instead. And the gamble of an incorrect guess is much higher with short selling than with traditional investing. In traditional investing, your upside is unlimited when you buy a stock, while the limit to your loss is all of your investment or 100% (if the stock price falls to $0). But, with short selling, the exact contrary applies. Your maximum profit is 100% (if the stock drops to $0), while your loss potential is technically unlimited. For instance, assume you short a stock at $25 per share. If the price were to drop to $0, your profit would be as high as it could go at $25 profit per share. But if the trade goes against your forecast, the stock could grow to $50 (100% loss), $75 (200% loss), $100 (300% loss), or even higher, making your losses potentially infinite.
Margin calls
If the stock you sell short rises in price, the brokerage firm can implement a margin call, which requires additional capital to maintain the required minimum investment. If you can’t provide extra money, the broker can close out the position, and you will incur a loss. On the other hand, this can function as a stop-loss provision. As potential losses on a short sale are unlimited, a margin call effectively limits how much loss your position can sustain. The major negative of margin loans is that they enable you to leverage an investment position. While this can bring the opportunity for extraordinary profits, it also multiplies your losses on the downside. Brokerage firms commonly allow you to margin up to 50% of the value of an investment position. A margin call will usually apply if your equity in the position plunges below a certain percentage, typically 25%.
Short squeeze
A short squeeze occurs when a stock begins to sharply and abruptly rise, and short-sellers cover their trades by repurchasing their short positions. This buying can become a vicious circle: demand for the shares attracts more buyers, which drives the stock higher, causing even more short-sellers to cover their positions. Short squeezes typically happen when a high percentage of all the stock’s outstanding shares are sold short.
The 2021 Gamestop frenzy
GameStop (NYSE: GME) is a video and computer game retailer had been shorted by Melvin Capital hedge fund since 2014. The stock was at $40 a share, and several Wall Street analysts had released research reports declaring the stock was worth even less. But rather than fall in price, GameStop shares surged in January 2021, at one point reaching $350. In short, GameStop had caught the fancy of retail traders who had clubbed together on Reddit and other platforms to drive the stock up. By inflating the price of GameStop shares, the day traders tangled the short-sellers in a short squeeze, where they couldn’t get out because the stock just kept going up. So while GameStop stock surged, hedge fund Melvin Capital Management lost 53%.
Pros and cons of short selling
Pros
The possibility of profiting on short-term declines in a stock’s value; Potentially significant gains without putting too much capital upfront; Hedge against a long position, i.e. shares you already hold in your portfolio; Leveraged investments; One of the few ways to make money in a bear market.
Cons
Potentially unlimited losses: leverage trading can be dangerous because it can massively amplify your potential losses, in some cases losing more than you had to invest in the first place; Upward market trend: over the long run, most stocks appreciate, meaning the overall trend is against you as a short-seller; A short squeeze: when a stock’s value skyrockets and short-sellers franticly scramble en masse to buy back shares to cover their position; Margin account necessary: if your account slips below the minimum maintenance requirement, you’ll be subject to a margin call and asked to put in more cash lest they liquidate your position; Margin interest: you have to pay interest on the borrowed stocks until they’re returned; Wrong timing: even though your hunch about a company being overvalued can be correct, it can take some time for its stock price to fall, and in the meantime, you will be vulnerable to interest and margin calls.
In conclusion
To sum up, short positions are bearish strategies since the stock is required to fall for the investor to profit. In addition, shorting is a high-risk, short-term trading method and demands close monitoring of your shares and meticulous market-timing. As a result, it may not be suitable for beginner investors who prefer taking a passive investment approach with their portfolios. Conversely, for active traders, short selling is a method that can deliver positive returns even in a looming bear market or a period of meager returns. But if you decide to short stocks, it is crucial to understand the risks fully and have a detailed exit procedure for getting out of the position fast if the stock price rises against you.
