Beginner’s Guide to Shorting Stock (Short Selling)

By Investor / Published on Monday, 20 Feb 2017 23:23 PM

The main idea behind making profits through trading stocks is to sell them at a higher price than you bought them(going long). The same holds true for shorting a stock, only that a trader sells the stock before they buy it. Confused?

WHAT IS SELLING SHORT?

Selling short refers to the sale of a stock that one does not already possess with the promise of giving it back.

HOW DOES IT WORK?

The act of shorting a stock can be rightly compared to betting against the market. Short selling is used to profit from a decline in share price.Here, a trader borrows a stock(hence the name short) from a broker who then borrows a stock from his large pool of clients before handing it over to you. A trader then sells the stock at, what they hope is,  a high price with the intention of buying it back later(to cover their short) in the future at a relatively lower price. The difference between the price a trader sold the stock and the price at which they bought it is the profit or loss that a trader has made.

Seeing as the stock is borrowed, a trader shorting has to meet any financial obligations that the stock requires. In the case of dividend stock, any time a dividend is paid out the trader shorting a stock has to pay dividends to the original owner of the stock until they cover their short(buy back the share they borrowed). Some brokerage firms require a trader to pay interest. A trader must then factor in these expenses during their trading.  

AN EXAMPLE

Suppose a trader(John) has identified the stock of a company (x) he feels is overvalued by the market. He sees an opportunity to make a profit before the market ‘corrects’ the market cap of this stock. The stock is trading at 50$ per share, and he would like to purchase 200 shares(10,000$). He’ll contact his broker/online and put in his order. One usually has to ensure that they have the minimum capital required in their margin account; this is standard practice as required by market regulators. Let’s assume that the minimum, in this case, is half the cost of the shares (5,000$). John’s margin account, therefore, has a balance of 5,000$ before the trade. His broker/ online broker then goes out to the market and find shares to lend to John. After filling John’s volume request, his 200 shares are sold at the market price (50$). The proceeds from the sale are deposited into John’s margin account. John’s margin account now has 5,000$ (minimum requirement for the trade)+10,000$ the proceeds from short-selling. John eventually has to cover his short by buying back the 200 shares he borrowed. Two things could happen:

The stock price goes down

A decrease in the value of a stock is ideally the most favorable outcome. Let’s say the price is now 30$ per share; John decides to cover his short and buys 200 shares at 6,000$. The shares are returned to the broker who lent them out in the first place. John’s margin account, after buying to cover is 15,000$(balance after short-selling) less 6,000$(the amount of which John bought back the stocks to cover his short)- 9,000$. John, therefore, makes a profit of approximately 4,000$ assuming there are no brokerage fees. That sounds good, but there is an alternative reality.

The share price goes up

Suppose the price of the stock went up to 75$. John decides to cut his losses rather than risk incurring more losses. He buys to cover the 200 stock at 15,000$. The shares are returned to their original owner as required. John’s margin account balance is 15,000$(the balance after short-selling) less 15,000$(the price of buying back 200 shares to cover his short)- 0$. John losses 5,000$ of his money, an undesirable outcome. The minimum requirement for his margin account is put in place to ensure a trader who short sells has enough money to cover their short if the price of the stock goes up. A trader would be forced to cover before their margin account balance is depleted. An adept trader would usually put in a stop order to minimize their losses.                  

What are the benefits of short selling to the market?

Market liquidity

Liquidity refers to the availability of shares to buy and sell in the market. Short-sellers increase the activity in markets thus creating a balance of sorts. The sale of borrowed stocks lessens the strain on potential shortages in the market.

They balance the market

Remember that shorting involves identifying overvalued stocks. The act of short-selling corrects the perception of such shares. If the value of said stock is right, then their price of the stock will stay up or rise, and the trader will have to pay up. If the value of said stock is incorrect, the share price will eventually fall to the benefit of the trader and the market in the long-term.
As always, it is important for one to carry out thorough research before placing a trade.   

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