Short Selling – A Beginner’s Guide 2022

Short Selling – A Beginner’s Guide 2022

Table of Contents

Short selling is one way to make money on stocks for which the price is plunging. Short selling ought to be simple if we go by theory. An investor borrows a stock, sells it, and subsequently purchases it back, returning it to the lender. However, it is an advanced strategy that only seasoned investors and traders ought to use in the real world. 

Short sellers are willing to bet that the stock they are short selling will plummet in terms of price. In case the stock does plunge after selling, the short seller purchases it back at a lower price, giving it back to the lender. The short seller’s profit is the difference between the sell and buys prices. 

Short selling: why do it at all?

Generally, you would short stock since you hold a stock’s price is set downwards. However, provided you sell the stock today, you will be able to repurchase it at a lower price in the near future. 

In case this strategy works, you may make a profit by keeping the profit between the price when you sell and the price when you buy. You might still end up with the same amount of stock of the same stock you had initially. 

Some traders are speculators and do short selling for that purpose. Others would like to hedge or shield their downside risk if they have a long position. 

Short selling: how it works 

Generally, you trade shares not owned by you when you short stock. 

For instance, in case you think a stock’s price is overvalued, you may determine to borrow 10 ABC stock shares from your broker. Then, in case you sell them at $50 each, you can keep $500 in cash. 

Simultaneously, however, you will have to purchase and return the 10 shares of stock to your broker. In the event of the price of the stock plunging to $25 per share, you may purchase the 10 shares again for a mere $250. 

The total profit would be $250. That is, the $500 profit made first, less the $250 you spend to purchase the shares back. But in case the stock goes beyond the $50 price, money is lost. So to buy back the shares and give them back into the broker’s account, you will have to pay a higher price. 

For instance, were the stock to go to $250 per share, you would have to spend $2500 to repurchase the 10 shares you’d owe the broker. So the net loss would amount to $2000, although you’d be keeping the original $500. 

Notably, calculating profit for a short sale is more contrived. You’d pay a minor commission. 

For the trade, extracted from your profit. Contingent upon timing, you might have to pay dividends to your shares’ buyer. Get the timing right, with InvestBy!

Short sale instance 

For instance, take an investor who thinks that at $325 per share, Meta, of ‘Facebook’ fame, is grossly overvalued and is sure to plummet price-wise. In that scenario, the investor could ‘borrow’ ten Meta shares from their broker, subsequently selling the shares for the current market price ($325). Then, if the price plunges to $250, the investor could purchase ten shares back at this price and return the borrowed shares to the broker, making $750. 

Nonetheless, in case Meta’s share price appreciates to $375, the investor would unhand $500.

Short selling: the risks

Short selling magnifies risk considerably. For example, when an investor purchases one FB share at $325, the maximum they could lose would be $325. The stock, after all, cannot palmetto less than $0. 

Nonetheless, when investors short sell, they may theoretically unhand an infinite amount of money. A stock’s price can keep appreciating forever. As in the instance above, in case an investor had a short position in Meta or had short sold it, and the price appreciated to $500 prior to the investor exiting, they would be poorer by $175 per share. 

Another risk that short sellers face is that of a short squeeze. This would concern a stock with a large short interest – that is, a stock that has been heavily short sold – appreciates swiftly in price. This precipitates a steeper price ascent in the stock as more and more short sellers purchase back the stock to close out their short positions, capping their losses. 

Is Short selling dangerous?

When you short a stock, you expose yourself to a large financial risk. 

A notable instance of loss owing to sorting a stock is the Northern Pacific Corner, 1901. Northern Pacific Railroad touched $1000. A few ultra-rich Americans went bankrupt as they tried to buy back shares, returning them to lenders.

If you are planning to sell a short stock, do not believe that you’d be able to repurchase it at a price you like, whenever it fancies you. 

When investing, you ought never to assume that, for a stock to go from price A to price C, it has to go thru price B. There has to be a market for a certain stock. There may be a considerable loss if no one is selling said stock; there are too many buyers, and other short-sellers are attempting to close out their positions.  

Short squeeze: Short Selling  

Early this year, Wall Street Bets followers from Reddit came together to lead to a massive short squeeze in stocks of wobbly companies with very high short interest, an instance being GameStop, the video games retailer. This facilitated the company’s share price rocketing 17 times, six times in January itself. 

Usually, short selling may only be undertaken in a margin account, a type of account by which brokerages lend funds to traders and investors to trade securities. Hence, the short seller has to surveil the margin account with precision to guarantee that the account always has enough capital or margin to maintain the short position. 

In case the stock that the trader has sold abruptly spikes in price, the trader will be compelled to pump more funds into the margin account straight away. Obversely, the brokerage may impose the closing of the short position, saddling the trader with the loss. 

It’s worth noting that in the event of an investor shorting a stock, there is technically no limit to the amount you lose since the stock may keep on app[reciating indefinitely. So in a handful of cases, investors can end up owing their broker money in every likelihood. 

The compulsion behind short selling: why do investors go short? 

Short selling may be useful for speculation or hedging. For example, speculators use short selling to take advantage of a potential depreciation in a particular security or generally across the market. Hedgers employ the strategy to shield gains or minimize losses in a portfolio or security.   

It is noteworthy that savvy individuals and institutional investors now and again engage in short-selling strategies for both hedging and speculation at the same time. Hedge funds remain among the most active short-sellers, frequently using short positions in select stocks or sectors, hedging their long positions in stocks. 

When is short selling right? 

Short selling is not a strategy many investors use. This is mostly owing to the expectation that the stocks will appreciate in value over time. In the long run, the stock market shows every tendency to appreciate. That does not stand in doubt despite the bear market’s punctuations. 

Short selling remains riskier than buying stocks for the ordinary investor with a long-term investment horizon. Short selling is right – in particular situations. These can be never-ending bear markets or if a company is going thru financial problems. 

Be that as it may, only mature investors with high-risk tolerance and cognizance of short-selling associated risks ought to attempt it. 

Is short selling costly? 

When you are short selling, trading commissions are not the only expense you have to reckon with. There are other costs, namely: 

  • Margin interest

Since short selling can usually be undertaken in a margin account, the short seller has to pay interest on borrowed funds; 

  • Stock borrowing costs

Some companies’ shares may be challenging as regards borrowal, owing to high short interest or limited share float. To borrow these shares for short selling, the trader has to pay a hard-to- borrow fee based on an annual rate. This can be relatively high, prorated for the number of trades the short trade is open ; 

  • Dividends and other payments

The short seller is also compelled to make dividend payments on the shorted stock, besides payments for other corporate events linked to the shorted stock, like spinoffs and stock splits. 

Is short selling profitable?

Hypothetically, the maximum profit you may make from short selling a stock is 100%, given that a stock’s lowest price for trading is $0. However, the actual profit on a good short trade can potentially be less than 100% once short position associated costs are factored in. These may be margin trading and stock borrowing costs. 

Can a trader lose more than he invested in a short sale? 

Yes, you may lose much more than you have invested in a short sale. In theory, your losses can touch infinity. Obversely, there’s the ‘long’ strategy, which says that the maximum gain on a stock is theoretically infinite. However, the most you stand to lose is the amount invested. 

By way of illustration, note how uninhibited price appreciation can inflict devastating losses on a short sale. An investor who had a 100 share short position in GameStop as of December 31, 2020, would be confronted with a $106.16 per share loss, or $30,616 , in case the short position were still open, come January 29, 2021. Since the stock soared from $18.84 to $325 over this month-long duration, -1,625% would be the investor’s return. 

Is short selling bad?

There’s a bad odour about short selling overall – the EU is especially unforgiving. We can thank shyster short-sellers who, with scammy tactics, drove down stock prices. 

When used as it was meant, however, short selling eases the functioning of the markets by offering market liquidity. It even acts as a reality check for fantastical expectations, thus diminishing the risk of market bubbles, allowing for downside risk mitigation. 

Safer alternatives to Short selling: profiting from a falling company

Safer alternatives to Short selling or profiting from a stock’s decline are options and inverse ETFs. 

Buying a put option allows you the right to sell a stock at a particular strike price. But, of course, the buyer has his heart set on the stock plummeting. So selling at the strike piece would be a jackpot moment! 

Inverse ETFs have swaps and contracts that effectively copy a short position. An inverse ETF is made up of diverse derivatives to profit from a depreciation of the underlying benchmark. Inverse ETF investing is largely akin to holding diverse short positions. The latter is also concerned with borrowing securities and selling them in the hope of buying them back at a lower price. 

Conclusion 

Market regulators in the UK and the US believe the ability to take long and short positions of special importance in many investment and risk management strategies can prove advantageous to a diverse range of investors. Examples of the latter include pension funds. 

Furthermore, a large number of hedge fund investors maintain balanced long and short positions. Therefore, if they are not able to increase or were mandated to reduce short positions, it would have a corresponding impact on their ability to increase or maintain long positions. 

Said regulators see short selling as critical pivots of the liquidity provision and price discovery as stipulated by market makers. Either you are a seasoned trader or in the hands of deft brokers like InvestBy. Only then can you hope to steer clear of trouble while Short selling. 

 

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