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Introduction To Short Selling

Short selling is a concept that many novice investors have heard of but do not fully understand.  Many people erroneously assume that short selling is restricted only to the “Wall Street billion dollar hedge funds” and high-frequency traders.  This is far from true as any qualified investor can short sell from their own brokerage accounts.

Short selling is the act of borrowing a stock and simultaneously selling it in the market with the intent of buying back the shares at a later date.  The stock is borrowed automatically from another client within the broker’s system.  There is often a small fee involved which is paid to both the broker and the other investor that agreed to ‘loan’ out the shares to someone else.  In order to short a stock, an investor will place a short sell order on their brokerage platform.  The process of buying back the shares is referred to as “short covering”.  If the stock drops in price, the investor makes a profit, but if the stock rises then the investor will lose money.  A simple example will help explain this.

How Short Selling Works?

The working of short working is quite complicated and difficult to understand. That’s why please read every line, word carefully. Once you know it, then it’s an easy game!

Short selling lets a trader sell stocks that he does not own. The trader borrows the desired share at the current market price from his broker, remember BROKER! And sells it to the market, at the current price;

Now, if the stock price falls, he has already sold the stock at a higher price, and now he’ll buy the shares from the market at the existing lower cost and will return it to the borrower.

Note to remember is- the borrower doesn’t care about the price of the share; he needs the exact number of shares, which you borrowed.

For this lending service, the broker charges a small commission, which is quite fair.

Example

Suppose Rebecca shorts 100 shares of Amazon.com which trades on the Nasdaq exchange at a price of $250 a share.  If in 2 months the stock has dropped to $200 a share, Rebecca makes a profit of around $50 a share as the broker charges additional commission and other fees.

Short sell revenue: $250*100 = $25000

Short covering cost: $200*100 = $20000

Profit: $25000-$20000=$5000

Suppose the price of Amazon.com has appreciated and in 2 months the stock is now trading at $300 a share.  Rebecca is now losing $50 a share and following a strict risk management system she has decided to cut her losses.

Short sell revenue: $250*100 = $25000

Short covering cost: $300*100=$30000

Loss: $25000-$30000= ($5000)

Short selling is considered to be risky as the losses involved are in theory limitless.  If Amazon.com were to skyrocket to $500 or more a share, Rebecca would face huge liabilities and would be forced to cover her losses.  This is why many brokers require investors to be more informed and investment savvy before being allowed to short sell stocks on their accounts. In addition, brokers can also stipulate their own risk management guidelines and reserve the right to cover a client’s short position if they deem the losses are becoming too Large.

Advantages of Short Selling

1. High Profits:

The first advantage of shorting a stock is traders earn a significant hefty amount from it. Also, when everyone’s losing, you will be ahead of them. And, it’s easier than nothing if you know how to do it. High profit is because of the margin facility available with the short selling. One can trade high volume even with little money and earn big.

2. Little Capital Requirement:

Traders do not need capital when going short. Short selling works on the principle of leverage and, and you need to pay a small fixed percentage of the trade value, initially.

3. Hedge against Others:

No doubt, short selling works as a hedge against other stock holdings. Many traders use it to reduce their losses if by any chance the market falls. When the market crashes, every asset falls, and you can use shorting against them to cut your losses.

4. Profit from Overvalued Assets:

Most traders complain that they missed the trend or lost the opportunity of earning from a stock. Stocks often get overvalued because of excessive demand, when rumours or hype creates. Not everyone can profit from them as they are spontaneous. However, it is much easier to spot these overvalued assets as they are everyone’s topic for talk.

By short selling, one can profit from them quickly, as eventually, they would also fall to their original price.

Conclusion:

If you are a new trader and thinking of using this tool, then we would advise you to be a little wary! Compare each aspect along with your goals, and then make a rational decision. The stock market has always gone up in more extended time frames. Thus, never go short for a more extended period. Also, do not forget to keep in mind the several costs associated.

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