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Short selling: an overview

Most traders or individuals earn or make profit from stocks/shares/equities that grow in value, while others profit from stocks/shares/equities that fall in value using a strategy known as short selling. We will conclude the Financial Advisory Series by talking about short selling.

What is short selling?

Short selling is when an investor borrows stocks/shares/equities from a broker or dealer and sells them on the open market with the intention of buying them back when the price falls in order to make a profit.

For example, you borrow 100 units of a company’s shares trading at 50 per share. You then sell them for 5,000. The price suddenly falls to 25 per share. You quickly buy back 100 units of the shares to replace the ones you borrowed earlier. This will give you a profit of 2,500.

Difference between long selling and short selling

Short selling is the polar opposite of the traditional procedure known as long selling. Long selling is when an investor buys shares with the expectation that the price will rise in the future, whereas short selling is when an investor anticipates a decrease in the share price.

Short sellers unlike long sellers do not own the stocks/shares/equities they sell in the first place. Instead, they borrow them from a broker or dealer, then purchase them back when the price falls, pocketing the gains/profits, and return the borrowed stocks/shares/equities.

How short selling works

A short position can be achieved in a variety of ways. The most basic way is "physical" selling short, often known as short selling, which entails borrowing and selling assets (usually stocks/shares/equities). In order to repay the stocks/shares/equities to the lender, the investor will acquire the equal number of the stocks/shares/equities. If the price drops, the investor will make a profit but if the price rises, the investor will lose money.

Short positions can also be obtained through futures, forwards, or options, where the investor undertakes an obligation or a right to sell an asset at a pre-determined price at a later date. If the asset's price falls below the agreed-upon level, it can be bought at a lower price before being sold at the higher price specified in the forward or option contract. Short positions can also be created through swaps such as contracts for differences.

Short selling may appear simple, but this type of speculative trading is fraught with danger. The process is described below:

  • You open a margin account to hold qualified bonds, cash, mutual funds, and/or stocks as collateral because you will be borrowing stocks/shares/equities from a broker or dealer.

  • You will be charged interest on the outstanding stocks/shares/equities' value until you return them, just like with other types of loans (though the interest may be tax-deductible).

  • You pay a fee to borrow the stocks/shares/equities (paid at a fixed rate over time, comparable to interest), as well as to compensate the lender for any cash returns due during the lease period, such as dividends.

  • Next, you begin to look for potential short sale prospects. To identify potential short sale prospects, traders often employ one or more of the following methods:

    • Fundamental analysis – Here, traders may examine firms with negative EPS and Sales Growth trajectories by examining their financials since a company's earnings per share (EPS) and sales growth tend to move in the same direction as its share price.

    • Technical analysis - Patterns in the stocks/shares/equities’ price movement might also indicate if it is about to enter a decline. Stocks/shares/equities that have been going through a succession of lower lows while trading at increasing volumes might be an indication of a seller's market.

    • Thematic - This strategy entails betting against firms or businesses whose business methods or technology or strategies are considered obsolete (think Blockbuster Video). This can be a lengthy process but can pay off if your forecast is true.

  • Before you start trading, you should determine your entry and exit positions as well as a possible stop order to minimize your losses if the deal goes against you.

Understanding the risks

What if the price climbs instead of falling? When this occurs, the seller must decide whether to keep the short position open or liquidate it at a loss. The market is unpredictable, and inaccurate projections in short selling might put an investor in massive debts.

Stocks/shares/equities can go up indefinitely but must come down sooner or later. The higher it climbs at a given point in time can also result in a loss for a short seller.

There are various risks associated with short selling, but these are the two most prominent:

  1. Potentially limitless losses – This is when you enter a short position on a company’s shares when it traded at 80 per share but instead of falling, it rises to 100 per share. You have to pay back 10,000 for borrowed shares. This is a loss of 2,000. If it continues rising, your loss position increases. Stop orders can assist to reduce this risk, but they aren't fool proof.

  2. Margin calls - Your broker or dealer may liquidate open positions to bring your margin account back to the minimum equity requirement if the value of the collateral in your margin account falls below the minimum equity requirement.

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