Investors and institutions know how much value they lose each day due to the rise and fall in the price of stocks on the stock market. Since traders are betting on what goes up and what must come down based on speculations, short selling is one of their strategies.
What is Short Selling
The short selling stocks is a very risky strategy in this business. It involves a stock trader or institution borrowing stocks from a stockbroker and selling off the stock immediately at its current price. The hope, usually from speculation, is that there will be a decline in the price of future shares. Then, the trader will buy them back and profit the difference. In essence, the trader gains from the amount he sold it at while refunding it at a reduced price – this is known as short covering.
Let’s say stock share ZZ can be shorted and client A wanted to short sell it. Client A goes ahead and borrow 300 shares at $10 per share from a stockbroker. The client then immediately sells it off at that price ($3,000). A week later, the stock share price actually declines to $8 per share and the client goes all in to buy back their borrowed share at its new price ($2,400). The client has made an impressive profit of $600 by capitalizing on speculation. Short-selling should only be done by traders that are fully familiar with the impending risks it involves.
Let’s not try to sugarcoat anything. Aside from being a very handy and profitable scheme in the stock market, short-selling is highly risky on different levels. When buying stocks traditionally, the potential losses that may be experienced are set at 100% of the original investment with potential gains being unlimited. But, with short-selling, the maximum potential profit or loss imbalance is reversed. Thus, the maximum profit is now set at 100% of the original investment and the potential losses become unlimited.
From the example above, let’s assume that the short-seller did not close the deal when the stock price declined to $8 and left it open in anticipation of capitalizing on a further decline. Suppose another trader, perhaps a rival company, waltzes in to acquire stock share ZZ because of its price decline before it could decline any further and announces a takeover sale offer for $15 per share. Remember, had client A had not bought back its stock share and decided to buy at $15, the loss on the short sale is $5 per share – amounting to $1,500. This is because the shares were bought back at a higher price, which is known as a short squeeze.
Short selling comes with a lot of costs. If a stock is difficult to borrow, short-sellers will be charged borrowing costs that may go beyond the short trade value. Hard to borrow stocks also come with buy-ins, where the lender requests his stock and forces the client to liquidate his assets or close the short position. Margin interest is also charged to the short seller because shorting can only be done in margin accounts. The short seller is also charged to pay dividends derived from the borrowed stock, which takes out a large chunk of any potential profit.
Before getting into short-selling stocks, you need to be fully aware of all the costs and risks involved in order to maximize your profits and avoid any surprises. Unlike traditional stock purchases, you are betting that the stock’s value will be decreasing over time. There have been many traders over time that have bet against stocks, real estate, and even governments and made millions. If you would like to learn more about short-selling, check out the book The Art of Short Selling by Kathryn Staley. If you would like to get a little more hands-on with your training, think about taking a course in learning how to trade from the professionals.
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