Experience investors prefer to use the trading technique of selling short. But hedge fund managers, are not the only ones that can benefit from this option for creating profits. At the same time, you should be aware, that if you decide to be a short seller, you can potentially lose a lot of money. If you are prepared to take on the risk, educate yourself, otherwise the gamble might not work.
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Thanks to Hollywood, the world of Wall Street has been demystified. The public has developed a perception that brokers live a high pace lifestyle. They make money by following their instinct on the stock market with risky trades. Enjoying the fruit of their labor in New York, the financial capital of the world.
Unfortunately, it is not that easy, to create a successful trading portfolio, as the silver screen will have you believe. It takes a lot of experience and knowledge to master stock trading. New York has been the epicenter of the stock exchange and has seen its share of successful brokers. While most of them prefer to open long positions. Buying stock and holding on to it. In anticipation of rising value or dividend payments. Some use tactics like short-selling stock, which promises faster profits. But when you open a short position, you expose yourself to potential risk, if your calculations are not correct. On the other side, fortune favors the bold!
Content
- Profit from the Devaluation of Stock Price
- How Short Selling Stocks Works?
- The Market Is Dynamic
- Practice with a Long Tradition
- Earned Billions Over Night
- Starting a Short Position
- Hidden Costs that Cut Profits
- The Disaster Called Short Squeeze
- Protection Against Short Squeeze
- Potential for Unlimited Losses?
- Set of Rules to Manage Risk
- Are Short Sellers Immoral?
- Blamed for Financial Crisis
- Beneficial for Markets
- Conclusion
- FAQ
Profit from the Devaluation of Stock Price
The process of selling short, involves the sale of stock that the seller does not own. It sounds strange to trade with something that is not yours. In reality, short selling is a legitimate practice that is done frequently. The method that is used is margin trading, using assets provided by a third party. The catch is that the seller borrows, the number of shares, that he intends to sell on the market, from another investor. The original owner is protected by potential losses and is compensated. The borrower is obligated to return the borrowed shares that he sold short at a preset date. The risk is all on the short seller.
The point of the short position is to benefit from the potential devaluation of the stock’s price. To do this, as a short seller, you need to have a quality estimate of the direction a certain industry or a company is heading in the short-term period. When the price of the stock falls. That is the time for you to buy it back and return it to the original broker. You keep the difference between the original, higher selling price and the new lower buying price, and make a nice profit. The amount you can earn varies, from few thousand to billions. It’s important to know when is the right time to close the short position because the market fluctuates.
How Short Selling Stocks Works?
Let’s take a simple example to illustrate the process of a short position. You decide that a company’s stock price, let’s call it Super Computers is overvalued. Their products and services are underperforming. The company has promised to revolutionize the IT industry with its new chip. The hype over the new gadget has made the stock’s price rise. It seems it has a stable position and its stocks are sold daily.
On the face of it, the margin for losses is small. But you have a sense that Super Computers are not going to fulfill their promise. So, the situation at the present is that the company is trading for $100 per share. You decide to short the stock. The way you open a short position is by borrowing 100 shares from your brokerage. Then you sell the 100 shares on the market for a total of $10,000. The amount is credited to your account. If your prognosis is correct, the stock will go down in value soon, let’s say to $70. At this time, you can buy back the 100 shares you previously sold. This time for $7,000, and return the original 100 shares to the broker you borrowed them from. The trade looks easy, and the math says you will make a profit of $3,000.
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The Market Is Dynamic
This may look like a pretty good quick profit scheme. You might think that short-selling would be just as common as owning securities. Surprisingly a small number of investors work with short sales. The reason for this is the behavior of the market as a whole. It makes sense that most investors have an interest in their stock to rise in value, not decline. They want to make money not lose. That is why they prefer going long, and build their portfolio with promising stocks. But the market fluctuates over a short period. Political and environmental crises can have a dramatic effect on a stock price at a given time.
Shares generally have an upward bias. For investors that play the long positions, owning stocks has been a much better bet than short-selling the entire stock market. Sell short is best suited as a short-term profit strategy. But some brokers specialize in short sales. If they find an investment that they are convinced will decline soon. Short-selling can be an option to make a profit from the crises that a company is experiencing. The process is complicated, it is a lot easier to go out and buy a stock, but you can make money when others are facing a shrinking portfolio.
Practice with a Long Tradition
Short selling is not a modern financial mechanism. It has roots in the seventeenth century. It is believed that the Dutch businessman Isaac Le Maire was the first to short a stock. There are documents from the Amsterdam Stock Exchange from this period that include contracts about short-selling stocks.
Over the years, selling short has gotten a bad reputation. It is known that it can cause downward pressure on the underlying stock. Driving down the price of shares of that security. This has made short-selling a historical target for criticism. After the collapse in 1772 of the banking houses of Neal, James, Fordyce, and Down in London, a major crisis followed that included every private bank in Scotland. The bank had been shorting East India Company stock. Using customer deposits to cover losses. This in turn affected the liquidity crisis in major banking centers.
Earned Billions Over Night
The most successful figure in the short-sale world is George Soros. He became a legend, and his bank account received several zeros overnight. Soros made a smart bet when he famously shorted the British pound in the early 1990s. This move made him a profit of $10 billion according to some estimates.
But his example is not the rule of the trading game. Yes, many people are making a nice profit daily. But many also experience failures because stock prices suddenly rise, and their problems are not advertised so publicly, like George’s success. The most notable example of going bankrupt due to selling short is the case of Northern Pacific Corner of 1901. When shares of the Northern Pacific Railroad rose to $1,000. Many millionaires in the United States had to give up this prestigious status. They lost money, trying to repurchase shares and return them to the lenders. Never forget you always have to return what you have borrowed!
Also Read: Best Trades Of All Time
Starting a Short Position
If you feel confident, and what to become an investor that does use a short position the opposite of his colleagues, then selling short is the trading game for you. Instead of buying stocks that you expect to rise in price you acquire and sell stock that you forecast will decline soon. Then here is a simple game plan to follow. Search the Internet or news media for stock prices and stories. That may indicate that certain industry, may face a slump for the upcoming months. This situation is a good way for you to cash in on the stock price falling.
Things to Be Careful About
You may be zeroing on few securities that look promising for short selling. But you should also check if there is demand for the shares and the stock price. If nobody is buying the shares, then what is the point of your borrowing them if you can sell them. You will only pay interest and be at a loss from the start.
You should also keep in mind not to be greedy and know when to close your short positions. If the stock you are using is volatile, the price could increase rapidly in hours. In most cases, your broker closes the trade if your margin account is not able to keep with the minimum requirements. You also need to be informed about the restrictions and rules for short selling in a given region.
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Locate the Potential Lender
The next step in becoming a short seller is to get your hand on a certain number of securities you plan to sell short. This works more or less like a bank loan. When you apply for a loan, the bank itself doesn’t have money. It takes funds from the deposit accounts of other clients, and loans you the requested amount.
Because the bank is providing you with the money, it charges interest on the loan. You agree to pay interest and to return the money after a certain period. The bank pockets the interest you pay for the loan and puts the original amount back into the depositors’ accounts.
The process is very similar when you are short selling a share. Your broker has an arrangement with his clients to lend their shares for a certain interest. This opens the window for you to borrow the stocks you anticipate will decline in value. Find a broker that has the stock you want to bet against, and put in a request for the borrowed shares. The broker will borrow the stock or will find an investor who has the number of shares in his portfolio and is willing to lend them to you. With an agreement for you to return them at a specific later date.
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You Need a Margin Account to Be a Short Seller
If you plan to short sell you will need a margin account to open a short position. You need a margin account because the practice of selling short is a trade with something you do not own. Margin trading essentially acts as a form of security, which backs the position and reasonably ensures the shares will be returned in the future.
As the short investor, you are borrowing shares from another investor. Selling them in the market. This involves risk as you are required, to return the shares in the future, creating a debt for you. Any proceeds from the sale of the stock are credited to your account. But the debt obligation to return the stock is also part of the agreement. That is why you can end up owing more money than you initially received in the short sale. If the shorted security moves up by a large amount. In that situation, you may be financially unable to return the shares.
The account is open by a broker essentially lending the customer cash to buy securities. Usually, the broker will set up limits on how much the client can purchase. Margin accounts also come with interest rates due payable to the broker, so it could be considered a short-term loan. A margin account can be kept open for as long as a short seller. As long as the obligations to the broker are still being met.
Compensation is Guaranteed to the Lender
It is important to remember that this is not a situation where they are just going to hand over the stock without compensation. You will be required to pay fees or interest on the stock to the broker for the privilege to barrow it and trade it on the stock market. From the point of view of the lender, he is in no danger. He will make a small profit by loaning you the share.
Once you borrowed the shares, you can sell them to a buyer. Of course, depending on the region you are in there are limitations for when and how you can sell. The time frame you are allowed to borrow the shares can vary greatly. In some countries, there is a rule that you will have to return the stock on the same day that you have borrowed it. This makes it difficult to effectively sell short. In the U.S. for example there is no limit to when you can sell. As long as the short seller’s margin account has sufficient balance, the share can be traded. Keep in mind that not all stocks are available every time. Some brokers do not allow the of certain stocks as they are either short sell heavily or there is non-availability of shares in the open market.
The Perfect Moment to Short a Stock
Once you have borrowed shares, you will immediately sell them. Then the patience game begins, and you follow the price of the stock and how it fluctuates in the upcoming days. This is the part where you need to have strong nerves and hope you have made the correct estimate. The point of the short position is to wait for the price of the stock to go down, and then you start buying back the shares you originally borrow and sold, but this time you get them back at a lower price. You pocket the difference and return the shares to the original brokerage.
Tips to Safely Sell Short
Success comes by planning and creating a sound strategy. We have put together a few tips to make it safer for you.
- Before you decide to go short make a complete analysis of the market and the price of stocks.
- Consider the company’s business model. Is it still relevant or are competitors overtaking them?
- Look for a company that often changes its management.
- Be mindful of your position size – the larger it is, the more risk is involved.
- Get notification when your market hits a certain level. Then decide what to do next.
- Place guaranteed stops to close your position once it rises to a certain point.
Hidden Costs that Cut Profits
You need to be aware of the extra costs that come with short selling. As we mentioned most brokerages, charge interest to borrow the stock. But if the company that has issued the stock pays a dividend between the time you borrowed the stock, and when you returned it, you must pay the dividend out of your pocket. You are responsible for the dividend payment, even if you already sold the stock and did not receive it. The reason is that the broker only lends the stock, and thus any dividend is the short seller’s responsibility.
The Disaster Called Short Squeeze
There is a stock market phenomenon, known as a short squeeze. This happens when a lot of short-sellers bet against a given stock, on the assumption that it will lose value. Unfortunately for them, the opposite happens. Most often, this phenomenon is fueled by the investor’s pessimism. Which turns into optimism for the market. The newfound interest in the stock means that there is confidence in its future. Not something the new investors were planning for the stock prices.
It creates a problem for the short-sellers, who need to focus on buying back more shares to cover their position in the stock. They must decide between continuing to pay interest on the borrowed shares, hoping the price will go down. The alternative is to exit their position. To accomplish this, they need to buy shares at the new higher price, and returning them at a loss.
But the higher a stock’s short interest, the fewer shares available for those short sellers to buy. It is a simple dynamic of supply versus demand. That sends shares even higher, further exacerbating losses for the short seller. Once investors begin to settle and exit their positions and demand for a stock begin to recede. Which usually sends shares back down to more conventional levels.
Also Read: Gamma Squeeze
Protection Against Short Squeeze
There are methods that you can use to protect against a short squeeze. In some cases, there is no escaping, the price rises daily. But you can alleviate its effects. You can manage the damage by place stop-loss orders on your short positions. For example, if you short a stock at $100 per share, put in a buy-limit order at a certain percentage above that amount. If the shares rise to that price, it will automatically trigger a purchase, closing out your position.
The alternative is to hedge your short position with a long position. You can also buy the stock to take advantage of price rises. By doing this you are betting against yourself. At least you lessen the and benefit from the price appreciation.
Potential for Unlimited Losses?
With any business decision if you make the right call you can be profitable. But what about the potential risks of a given strategy. When you short a stock, you have limited profit potential but unlimited risk. This is the opposite situation of what you can experience when you buy a stock. The most you can lose when you are buying a stock is losing the money you paid for it. The stock can go down to zero, in this case, you will have a complete loss on your investment. But that is the limit of how much you can lose. The contrast with if the stock rises in value, there’s no limit to your profits. It’s common for long-term stock investors to earn profits that are several times the size of their initial investment.
The dynamic is different with short-selling. You are limited on your potential profit, but not on your losses. Let’s take another example. You borrow 100 shares and sell the same 100 shares at $50 per share. Your proceeds from the sale will be $5,000. If the stock goes to zero, you’ll get to keep the full $5,000. However, if the stock soars to $500 per share, you will have to spend $50,000 to buy the 100 shares back. That will give you a net loss of $45,000. If you think this is not possible or highly unlikely to happen, check the trading history, you will find cases of rapid stock rise that have bankrupted people they call them self’s millionaires.
Set of Rules to Manage Risk
Short-selling is a risky tactic, but it can be a useful maneuver if you know what you are doing. Used in moderation, short-selling can diversify your investment exposure and improve your personal finance. It can allow you to capture better returns than someone who only owns stocks and other investments.
Selling short has its own set of rules, which are different from regular stock investing. For example, if the price of a stock has devalued over 10%, compared to the previous trading day. Then short selling is restricted on the given stock. In theory, the risk of losses on a short sale is infinite. A stock’s price could continue to rise with no limit. The short-selling tactic is best used by traders who understand the risks.
Are Short Sellers Immoral?
Very often short-sellers are blamed for causing a downswing in the market by opening short positions that will generate more profit for them. They have been accused, of deliberately devaluing stock, pressuring other brokers to go short, further decreasing the share price. This is a misconception because, in reality, short selling has little effect on the share price.
The idea that short selling is causing trouble for companies comes from CEO that are facing problems, and want to shift the blame to somebody else. There have been even suggestions that short-selling should be made illegal.
Another factor causing short-sellers to be viewed, with suspicion is the ban on short-selling during times of economic distress. During the 2007 financial crisis, regulators around the world restricted short-selling. They do this when they try to protect falling markets, which leads to short-sellers being perceived in a negative light.
Blamed for Financial Crisis
Short sellers were accused of causing the Wall Street Crash of 1929. Regulations were implemented in the United States in 1929 and 1940. The depression that followed the 1929 crash, forced Congress to ban the practice during a downtick. The Securities and Exchange Commission removed this rule in 2007.
During the dot-com bubble, shorting a start-up company could backfire since it could be taken over at a price higher than the price at which speculators shorted. Short-sellers were forced to cover their positions at a price similar to the acquisition prices of the initial trade. In many cases, investors often overpaid for the start-up.
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Beneficial for Markets
A short sale is important for forex and stock markets because it ensures securities are priced correctly. It also helps increase market liquidity. A large number of people are short-selling securities on any given day. This enables a buyer to trade the asset because there is a constant supply. Research has discovered that restrictions on short-selling can cause a lower trading volume. In a way, it is integral to financial markets. Liquidity from a short position also leads to a significant narrowing of spreads, which results in reduced costs for investors.
Markets over the world, have embraced short selling. They consider it as a counter to companies who try to inflate their stock’s price. The extra benefit that short-sellers bring to financial markets is intense scrutiny of a company’s financial statements and prospects. The uncovering of any sensitive information allows investors, to better assess their investment decisions.
Conclusion
Short sell is an old trading tactic, that has evolved parallel with the stock market. It is a lucrative style of investing if done right. Going long is the preferred approach for trading on the stock market. But at the same time stock that is sold short can be a solid investment, and security is not a problem if you cover all the aspects of the trade. The key is to have confidence that the price of the stock will decline. And you will be able to buy back the shares you borrow, at a price that is lower than the one you sold them. That way making good on your financial investment without a large margin in risk.
It has received all kinds of criticism. But shares that are sold short do not hurt the financial market if done reasonably. In reality, is that short sales reveal new information about a company’s prospects. The short sellers help keep enthusiasm in check and often uncover fraud. Taking into account the market’s long-term upward bias, many investors find it hard to short stocks and achieve consistent results. It can also be a profitable strategy to increase your personal finance if you make the right choices and luck is on your side.
Also Read: Day Trading For Beginners
FAQ
Why short selling is bad?
It can be a bad investment if you don’t know what you are doing. There is a high risk of losing money if the share rises in value, instead of the expected devaluation. When this happened there is theoretically no limit to the amount you can lose.
What is the short-selling technique?
Short selling is a process of borrowing shares from a brokerage agency for a fee or interest, and selling them on the market. Then you wait for the price to go down and buy back the stock, making a profit on the deference.
Is short selling illegal?
No, it is legal to sell short a stock. There have been times during financial crises. When government institutions, have placed a temporary ban on the activity, to stabilize the market. But generally, it is legal to short a share.
Why is it called short selling?
The term comes from the fact that the stock is owned for a short period. The point of the transaction is to make a profit by borrowing shares and immediately selling them in hopes they will decline in value. Allowing you to repurchase them later at a lower price, repay your debt, and walk away with a profit.
