What is shorting a stock?

If you’d like to know how does shorting a stock work, you can turn to the feature film The Big Short, which is based on real events. Its prototype was the 2001 record of the largest profit per week from trading. The uniqueness of the situation is that at the same moment, millions of investors were losing money on the collapse of the real estate market and associated banks.

Principles and features of margin trading 

The principle of classical stock trading differs little from ordinary stock speculation. An investor or trader buys an asset, waits until the price rises and sells with a profit. With a physical purchase, dividends become additional income, if the company accrued them during the period of ownership. If you are wondering what is shorting stock, it’s a way to make money on stocks that are not available, potentially profitable speculation in virtual assets.

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What is a short position – principle and key concepts

You can make money on physical investment in stocks only if their price rises. When a trader wants to short a stock in the stock market, a trader earns on a fall in asset value. The point is to sell the asset at a high price, and as soon as the price drops, buy it back with a profit. The main nuance of the short game is the preliminary loan from the broker – that is, the trader initially sells the borrowed papers, and after conducting transactions returns it, keeping the profit. A simple practical example will clarify the process:

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Features of borrowing shares from a broker

In the example of how to short stocks, everything looks simple, but there are subtleties. Margin lending is available only with specific collateral – the amount by which losses can be repaid. If trading also uses leverage, which increases both income and risks, the amount will be significant. Funds sufficient for repayment will be blocked at the time of margin lending processing.

Two concepts are important here – the initial and final margin. Initial is the starting supply for the transaction. To derive a ratio, asset value is multiplied by the risk rate. The minimum margin is 1/2 of the initial margin, which is the minimum required to maintain a position.

To determine the loan limit, the broker calculates the value of the liquid portfolio – subtracts the client’s debt from the price of the client’s assets, which will go towards paying for the borrowed shares if and when the trader’s total balance is in the red. That is why it’s not worth it to borrow too much and use excessive leverage – the broker will receive his money in any case.

For operations, the broker will take a commission, as in normal transactions. But with a loan, an additional percentage will be taken – a fee for keeping a short overnight. If a trader “borrowed” shares from a broker, sold them on the same day, was able to buy cheaper and repay the debt to the broker, then no interest is charged. If the process stalled and all transactions couldn’t be conducted on the same day, an additional commission will be charged – the daily loan payout.

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Practice and risks of short trading

The secret to the success of short trading is the timely detection of the uptrend’s deterioration. 

These “symptoms” include:

• a long uptrend without rollbacks and the first attempt to drop;
• the appearance of a gap down on high volume or large sales without recovery attempts;
• failed attempts to go above the 50- or 200-day SMA.

Why sell short?

People short sell because of hedging and speculation.

Hedging a long position is one of the most common reasons to sell short. If you possess long-position call options, you can lock in profits if you sell short against the position. You may also be interested in limiting downside losses without having to leave a long stock position. In that case, you have the opportunity to sell short in a stock that highly corresponds to it or that is closely related to it.

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Speculation also leads to short selling many times. Speculators make bets at a pure price that they are going to decline later. If they make a mistake about it, then they will purchase the shares back higher and incur losses. But as margin use increases the risks in short selling, the process takes place over a smaller time frame, meaning it has higher chances of being done for speculation.

·  Example of short selling for a profit

Let’s say that a trader sees this stock that is currently trading at $100. He thinks that within the next three months, there will be a price decline in it. So, he decides to borrow 100 shares of it and sell them to an investor. Borrowing the shares and not actually owning them makes the trader “short” 100 shares.

Borrowing the shares is what made the short sale possible, though. If the stock is significantly shorted by other traders already, a short sale may not be possible.

After two weeks, the firm whose shares were shorted talks about bad financial results and the stock ends up falling to $80. As such, the trader closes the short position and purchases the 100 shares for the $80 price on the open market, replacing what he had borrowed. This way, the trader makes some profit.

·  Example of short selling for a loss

For this type of short selling, we’ll use the example above. Let’s imagine that instead of closing out the short position at $80, the trader decided to leave it open to capitalize on another price decline in the future. In the meantime, a competitor manages to buy the company by making a takeover offer of $120 per share. The stock ends up rising.

Then, if the trader closes the short position at $120, he will lose money on the short sale because he had to buy the shares back at a much higher price.

·  Example of short selling as a hedge

Short selling is also great for hedging and hedging is thought to be safer.

As an example of short selling for hedging, let’s say that a portfolio had 50% of it in very close correlation with the Standard & Poor’s 500 Index and it is hedged. Then, if the index goes up 15% during the following year, the portfolio will record half of this gain only. This would mean a 7.5% gain.

Pros and Cons of Short Selling

Short selling has its pros and cons, just like any other type of activity. For instance, if the seller doesn’t make the right guess regarding the price movement, selling short will cost a lot.

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If a stock purchased by a trader goes to zero, then the trader can lose 100% of their outlay only. Nevertheless, someone who shorted a stock can actually end up losing way more than 100% of the investment they initially made. Because there is no particular limit to the price of a stock and it can rise beyond what the trader thinks, the risk is higher.

Here are the overall benefits and drawbacks of short selling:

Pros

·  Very little initial capital is needed

·  It’s possible to make high profits

·  You can hedge against different holdings

·  It’s possible to make leveraged investments

Cons

·  Short squeezes

·  You can incur margin interest

·  You need a margin account

By all means, please remember the risks associated with stocks that are shorted. Short-term positions are considered the most unpredictable. To work with shorts, you need to have a good command of fundamental and technical analysis and have a great degree of self-control.