Shorting stocks come with a lot of risks and if it pulls off well, you can take advantage of stock prices falling and make money from it. If only you are willing to accept the risks.
Maybe you have heard someone mention some time ago, that they wanted to short a stock, and you have either been wondering what that meant or how you could go about it. First of all, let’s get clarity on what a stock is.
What is a Stock?
A stock is likened to a collection of a corporation’s shares which define the proportion of ownership of that establishment by investors. When it comes to the stock market, one may either choose to go long or short. To go long is to speculate a rise in the price of stock in the future, thereby buying such stock in order to sell back when the price eventually goes up. On the other hand, going short is the complete opposite. The trader sells a stock with an expectation that the stock price would fall in the future. When the price finally drops as expected, he buys back the stock. In either way, the goal of going long or short is to make profit from the trading.
Understanding How to Short a Stock
Basically, shorting stock or short selling has to do with selling borrowed stocks by a short seller to make profits. Short selling is a popular trading technique used amongst traders, speculators, hedge fund managers, individual investors, arbitrageurs, and gamblers, who are willing to risk capital loss to make profit.
The basic idea behind short selling is that short sellers believe that if they sell a stock at a current price, in hope that the price would decline soon, they would be able to buy back the stock at a lower price if eventually, it falls as expected. If all goes well, the short seller would make a profit generated from the difference between their selling price and buying price. Some other traders short stocks for hedging their portfolios while others simply do it for speculation.
One way to take advantage or capitalize on plunging stocks is by ‘selling short’. Usually, investors buy shares and stocks with the hope that these stocks would rise in value with time. However, this is not the case with some, as the establishment may record a decline in profit and net worth, thereby resulting in a corresponding fall in the market value of the stock. In this case, a trader may still consider such to be an opportunity, by attempting to short the stock in order to make profit from that decline. This strategy is also referred to as short selling.
The basic procedure for shorting a stock is to “borrow” the stock from a shareholder, find a buyer and sell the stock at a particular price. Then, after a period of time, when the price must have fallen as anticipated, the stock is bought back (at a less expensive rate) and returned to the owner. This seems to be a simple process, because much of the work is handled by a stockbroker, who helps in finding a buyer and executing the trade, and does all for a reasonable commission.
A more detailed procedure is outlined and discussed below:
1. The first step is to identify the stock that you intend to short
2. The next step is to find the right broker that will help facilitate the trade. Each broker may have unique requirements and charge commission rates that might differ from the others. You just need to find one that you would be comfortable with.
3. You need to ensure that you have opened a margin account with the selected broker. There is usually a minimum amount that this account is expected to maintain in order to keep the trade running.
4. Once all requirements are met, you can now borrow the shares/stock from the shareholder, which you would then sell to the stock market through the broker.
5. The final major step is to close position and return the stock to the original owner.
6. Between the sale time and the time when the stocks would be bought back, the price is expected to have dropped. If that is the case, you will buy the originally sold stock at a price less than the selling price, thereby making some profit. If the price does not rise according to your speculation, it means you will be at loss, at you will have to get extra funds to recover the stock. It is also possible to break even if the closing price is the same as the opening price.
If Disney shares are trading for $50 per share, which you may perceive “too high” with a possibility of dropping sometime sooner or later. Through your broker, you can access and borrow a hundred shares from another investor. You will then sell the shares at $5,000 in hope that at your predicted time the prices would fall. Three weeks later, it was reported that the company was experiencing a financial decline for whatever reason and its stocks drop to $30 per share. At this point, you buy back hundred shares of Disney at $30 per share (100 x $30 = $3,000). You are buying hundred shares at a profit. Once you buy back the hundred shares, you will sell them back to your borrower at $3,000 and keep the $2,000 profit for yourself.
This is a basic example of how short selling works but extra costs and charges apply. Many brokerages charge extra fees for borrowing or demand a certain percentage of the profit you make. All charges and dividends would be paid from the profit made. The downside to shorting stocks is that whether or not the seller makes any profit they are responsible for dividend payments.
Major Risks Associated with Shorting Stocks
Short selling is targeted at short-term stock investments or other investments that are on the verge of a price decline or are suspected to decline in a little while. Many investors consider shorting stocks risky because the value would eventually increase and could result in a loss for the seller. There is no determining the potential price of a stock and the potential loss of a short position per time.
The first thing to know about short selling is that there is always a high probability of capital loss. Therefore, short sellers are always exposed to high financial risks. There is no guarantee that sellers will be able to buyback or repurchase stocks at their desired price and the time they deem fit. Price movements in the market are unstable and uncertain, therefore, short sellers must be ready to take the risk and prepared to change with the tides at all times. Asides the uncertainty of the markets, short sellers can also be at risk when some traders or investors see that a stock has a high short interest, which means that a stock has the possibility of bringing in large returns. These traders make an attempt to drive up the stock price. By doing this, investors with short positions would have to quickly buy back the shares before the price jumps higher. This would cause huge losses among short sellers who expected the prices to drop instead of sky-rocketing.
Also, short selling can cost the seller more if there has been a wrong prediction about the price movement. If a stock moves to zero, a buyer can lose 100% of their outlay. A short seller can also lose 100% and more of their original investment as there can be an unlimited increase in a stock’s price. There is also no telling how long a stock price would remain low.
Shorting also has to do with margin. In an event where the stock price increases contrary to what the short seller expected, the seller would be subject to a margin call. Through the margin call, the short seller would be required to make a deposit of additional funds into the account equal to the original margin balance. Traders must also learn to calculate the cost margin interest per shorting while calculating their profits.
There is also a possibility of short sellers getting stuck in a short squeeze. This happens when a short seller has difficulties in finding shares to buy when it’s time to close a position. This usually occurs when there are a lot of traders selling short or when a short it thinly traded. The major cause of this is when a certain stock begins to surge or when the market experiences an increase.
There are other risks associated with shorting stocks such as;
- Using borrowed money to invest
- Wrongly predicting price moves
- Getting stuck in a short squeeze
- SEC short selling regulatory
- Selling contrary to the trend
Benefits of Shorting Stock
Contrary to the risks associated with shorting, there are also quite a few benefits for short sellers if they play their cards well. Most times, high-risk investments offer high-yields and short selling belongs to this category of high-risk high-yield investments. If a short seller is able to rightly predict the price moves of the market or particular stocks they can make a good ROI; especially if they use margin to run the trade. Margin helps the short seller secure leverage, that is, the seller didn’t necessarily have to put in so much of their personal capital as an initial investment.
Many short sellers also use short selling as a strategy to hedge their investments. By hedging, short-sellers or investors encounter lower risks. They are also able to protect their profits or mitigate losses in their portfolio. Hedging may seem like a good strategy for investors avoiding losses, however, it comes with its own costs. First, there is the cost of setting up the edge. This cost includes payments for short sales and/or protective options contract premiums. Next, there is the opportunity cost associated with the capping of a portfolio’s upside if the markets continue to surge. For example, if 50% of a short seller’s portfolio is hedged and correlates with the S&P 500 index. If the S&P 500 climbs 17% over the next 12 months, the portfolio would record half of the gain or 8.5%.
Terminologies Associated with Short Selling
Opening Position: This is the point at which you initiate the trade. The price of this position is the opening price.
Closing Position: It is at this point that you exit the trade, and buy back the stock you sold at the opening position. If all goes as speculated, the closing price (price at the closing position) should be less than the opening price, in order to make a profit from the trade.
Short Position: This is a technique investors use to anticipate the decline of stock value in the short term. The short seller expects that the price of a stock would drop in a few days or weeks. There are basically two types of short positions: naked and covered. The naked short involves traders who sell a security without having any ownership on it. While a covered short has to do with traders who borrow stocks from other investors through a legal loan department or brokerage.
Long Position: This is quite the opposite of shorting. A long position is a technique used by traders and investors who buy stocks and hold for a long time with the expectation that there would be a rise in value. They are mostly used when an investor would like to purchase an options contract. Depending on the underlying asset involved, the trader or investor can either hold a long call or long put option. The call option is reserved for traders who hope to profit from an increase in price movement. While the put option is reserved for traders who anticipate the price drop of an asset, having the right to sell the asset at a certain price.