Selling Short: how to short a stock

November 25, 2020 - Владимир Кулаков

Selling short – is a trading practice in which trader takes advantage of the price drop on the market. While selling long is a strategy that takes advantage on the growth of prices, and is, therefore, easy to grasp, shorting is considered an advanced strategy. It’s true that short positions imply greater risk and require more sense and prowess, but they aren’t very difficult to understand.

To put it simply, while selling short you invest the borrowed shares (or other assets) and open the position with the funds that represent these borrowed securities. Then, when the price on the shares you borrowed eventually drops, you can buy them back at a smaller price. This way, you’ll cover your debt and have something extra to continue investing. This is how selling short works, basically.

This, however, is just a tip of an iceberg. There are certain requirements needed to start trading short.

How to short a stock

Margin trading is a form of trading, in which you use the borrowed funds instead of your personal investments. In essence, margin trading is the same as short trading. Of course, there are nuances, but they aren’t important here.

The crucial part is, in order to start trading marginally you’ll have to set up a margin account at a platform of your choice. Margin accounts are fairly popular. You can set it up on virtually any respectable brokerage platform.

After you’ve set up a margin account, you can start borrowing the funds needed to open your short position. The broker is most frequently the one who lends the funds, and these funds are collateralized by the shares and securities. It basically means that you buy the securities yourself and only hold their value in currency.

However, it’s not that easy. Brokerage companies from whom you borrow money always charge you additional fees on your loan. The interest is the most prominent and expected of them. As with every loan, your interest rate is discussed prior to the lending.

There are different ways to use the marginal loans, shorting is just one of them. The most profitable strategy is to make a short-term investment and reap the benefits until the interest grew too great.

The risks of short selling

All trading strategies are associated with some risk, but short selling has some very tangible risk. Here are several cons of trading in such a way:

  • If you invest with somebody else’s funds, and not yours, if case of loss you’re accountable to the lender. There are several rules of margin trading that keep should be taken into account before taking a debt – for instance, how much the interest can rise in case of loss, what are the other fees, etc.
  • You are not the only one trading short. When the price strikes its lowest point, you’ll see just how many short-sellers there are. You may simply not find enough shares to buy back when the time comes. If you don’t, the price can rise and you’ll be forced to either buy at a loss, or continue accumulating interest until another great fall comes.
  • There is a potential danger of losing much more than you invested into the short position. Remember: you’ll have to buy back the stock you borrowed – and if it suddenly starts to grow exponentially, you will have to realize what’s coming and bail until it’s too late.

The main problem behind short selling is the inability to conduct long-term investments. That’s in the name. If the long trading allows you to wait for the very long periods of time until the price hits the most favorable spot, short positions must be closed as soon as possible, because margin interest is no joke.

If you miss to buy back cheap, the best possible scenario is the loss of profit. However, if the price suddenly grew higher than the price at which you borrowed the securities, you’ll have two options:

  1. Wait until the value drops again and risk accumulating large sums of interest. In this case, a large portion of your profits will be used to cover the interest expenses.
  2. Buy at a loss and use your own funds to balance out the losses. That’s why you’ll need to add extra funds to your margin account before you start investing.

The benefits of short selling

So far, it seems like trading short is a very risky affair with unjustified dangers. It’s true that most people utilize highly speculative tactics while trading on short and that it’s often impossible to fully predict the movement of prices.

However, even such approach has a lot of prominent benefits:

  • The initial investments are minimal. It’s true that you’ll have to keep a sum of money to offset the imbalance if you’ll have to buy at a loss. Additionally, if the position proves unfortunate, you’ll have to find more funds to pay back the debt. However, if you’re 100% sure that some time later the prices will drop, you can take advantage on it by placing a short position.
  • Leveraged trading is also available. Depending on your situation, you can borrow some amount of stock from and use your own funds to buy and sell the rest. Additionally, you can secure your new deposit by playing hedging strategies. It says a lot about the flexibility of short selling.
  • In theory, a series of successful short positions can bring large profits to the investor without any significant initial investments. You open the position, wait until the drop, buy the lent stock + the additional shares, then return the lent assets and continue investing. However, it requires a very keen eye for the market movements, as well as a good sense of when to buy

In conclusion

Short sell is still a fairly dangerous type of mainly speculative investing. Its key element is speedy execution. Each investor is playing against the time, because of the interest fees that increase the amount of loan they’ll have to return.

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Because of the interest, investor is somewhat obligated to close the position as soon as possible. In contrast to this, there is a similar strategy of asset investing called put option. Put options give traders an ability to sell shares on some designated date at a designated price. Options are called so, because you don’t have any obligations, you only have a right to sell, that you can use or give up.

In this sense, you may consider trying put options before proceeding to open short positions. They are fairly alike, the options, however, don’t have nearly as much associated risk.

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