Short Selling
What is short selling?
Short selling is an investment or trading strategy that speculates on a decline in the price of a stock or other security. This is an advanced strategy that should only be undertaken by experienced traders and investors. Traders can use short selling as speculation and investors or portfolio managers can use it as a hedge against the downside risk of a long position in the same or a related security. The speculation involves the possibility of substantial risk and is a method of trading. Hedging is a common transaction involving placing an offsetting position to reduce risk exposure. In short selling, a position is opened by borrowing stocks or another asset that the investor believes will decline in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the actions of the borrower be returned, the merchant bets that the price will continue to decline and buy them at a lower cost.
KEY CONSEQUENCES
- Short selling occurs when an investor borrows a security and sells it in the open market, planning to buy it back later for less money.
- Short sellers bet and profit from a decline in a stock's price. This may be contrary to long investors who want the price to
- Short selling has a high risk/reward ratio: it can offer large profits, but losses can increase rapidly and infinitely due to margin calls.
Understanding Short Selling
With short selling, a seller opens a short position by borrowing stock, usually from an intermediary, in the hope of buying it back at a profit if the price drops. Shares must be borrowed because you cannot sell shares that do not exist. To close out a short position, a trader buys back the shares in the market, hopefully at a lower price than they borrowed the asset, and returns them to the lender or broker. Traders should consider any interest charged by the broker or commissions charged on trades.
To open a short position, a trader must have a margin account and will generally be charged interest on the value of the borrowed shares while the position is open. In addition, the Financial Industry Regulatory Authority, Inc. (FINRA), which enforces rules and regulations governing registered brokers and brokerage firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount the margin account must hold, known as the maintenance margin.1 If an investor’s account value falls below the maintenance margin, additional funds are required or the position may be sold by the broker.
The process of identifying which stocks can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be done through normal trading platforms with most brokers. However, each broker will have qualifications that the trading account must meet before allowing margin trading.
Why sell short?
The most common reasons for engaging in short selling are speculation and hedging. A speculator makes a pure bet on which price will fall in the future. If they are wrong, they will have to repurchase the shares higher, at a loss. Due to additional risks in a short sale due to the use of the margin, it is generally conducted on a smaller time horizon and is therefore more likely to be a task conducted for speculation.
Advantages and Disadvantages of Short Selling
Short selling can be costly if the seller guesses the price movement wrong. A trader who has bought stocks can only lose 100% of their expenses if the stock drops to zero.
However, a trader who has shorted stock can lose much more than 100% of their initial investment. The risk comes from the fact that there is no cap on the price of a share, it can go up “to infinity and beyond”, to use a phrase from another comic character, Buzz Lightning. Additionally, while the shares were held, the trader had to fund the margin account. While all is well, traders need to calculate the cost of margin interest when calculating their profits.
When it comes time to close a position, a short seller may have difficulty finding enough stock to buy if many other traders are also short in the stock or if the stock is trading poorly. Conversely, sellers can be captured in a short cycle if the market, or a particular stock, begins to climb the stars. That said, short selling through ETFs is a bit safer strategy due to the lower risk of a short sale.
