The trading strategy of short selling is often used by traders to take advantage of stocks that are likely to go down in value. There are a number of ways in which a stock can be short sold, so understanding how to do it and what the different methods are is particularly useful.
What does it mean to short a stock?
Selling a stock short, or as it is also known, shorting a stock is a trading strategy that benefits from the price of a stock going down rather than going up. The usual convention is to buy stock that is likely to go up in price. This is known as taking a position that is long or simply, going long.
By holding a short position on a stock it allows traders to hedge against their long position in case the markets go down. It is also a way of benefiting from bearish market conditions.
How is it done?
Firstly, it must be decided whether to either invest in stocks or speculate on movements in their price using derivatives. Then a position on the stock that is to be shorted is opened. The markets are monitored in order to see if the price of the stock changes. If the price of the stock goes down as anticipated then the position is closed and the stock in bought back at the now lower price. The difference in price is the profit. However, if the price of the stock was to go up instead and close the position by buying the stock back at a higher price, then the difference is the loss made.
Begin short selling
There are a number of ways in which an investor can begin short selling stocks. Although the steps included are all very similar, the specific details of the different processes depend on the method that is used.
An example of how the process works is as follows; the stock of a company is currently trading at $50 per share, which the investor thinks is highly overpriced. Because of this, they anticipate that its price will go down and decide upon shorting the stock. The outcome of this solely rests upon the method that is used:
Trading with leverage- With this type of trading you are never required to take actual physical ownership of any assets bought to be able to open a position on them. All that is required for the short position to open is for the investor to pick the option to sell on the deal ticket. With this method there is no need to every worry about having to borrow shares from the brokerage firm because it only involves speculating. Because of this there are no brokerage fees to be paid.
Short selling traditionally – This method sees the investor borrowing from the current owner of the shares and then selling them for whatever their current price is. If the price of the stock falls, the investor is able to buy these shares back at the current lower price, making a profit from this difference. It is usually large financial institutions that partake in this method rather than individual investors. Borrowing shares for a short sell requires the investor to pay a fee.
Options trading- This is a highly popular method of short selling stocks. Investors are able to buy the option to sell shares should the price of the stock go down before the date of expiry. If the price of the stock does not go down then the investor can close their position, providing it is before the expiry date (options have a limited life span), and the only lose they will have is that of the premium paid to take the option out in the first place.
The risks of short selling
At first glance the trading strategy of short selling may seem rather simple and straightforward, there are actually a number of risks associated with its practice. These include:
The ability to make unlimited losses – In theory an investor can make unlimited losses by holding a short position, providing the price of the stock goes up in price rather than down. For those using derivatives a stop can be attributed to any positions held in order to protect the investor for making large losses.
The possibility of being short squeezed – This can occur when the price of the stock goes up and sellers holding short positions act quickly to get rid of their shares, thus sending the price even further up. This again causes investors with short positions to sell their stock.
Being unable to borrow stocks – It could be the case that an investor struggles to find a brokerage firm that is happy to lend them any shares to initially borrow. This is referred to as unborrowable stock.
Other than the risks just mentioned, the trading strategy can also influence the market as a whole. If enough investors are shorting a stock, their combined influence can work to determine the price of the stock. It has been known that some investors have been banned from this trading strategy. This was particularly true during the global financial crisis in 2008, when a ban was placed on the short selling of the stock of specific financial institutions and banks.
What to remember when considering short selling stocks
The process of short selling sees investors borrowing shares from a brokerage firm to sell them at their current value and then, once their price has gone down, buy them back to profit from the difference in their value. It is a useful tool for investors to hedge against their long positions. The alternative methods to the traditional method include trading with leverage and options trading. As with any form of trading, there are risks involved with short selling stocks, such as incurring unlimited losses, being short squeezed, and being unable to borrow any stocks.
All of this should be remembered and considered before opening an account and thinking about short selling. To learn more about it you can check out https://www.timothysykes.com/blog/how-to-short-sell-stocks/.