Many investors made money by “short selling.” How did they manage that? Short selling strategies offer high risk but high rewards.
Short selling stocks carry big risks, but when this trading technique is done properly, it might provide huge returns as much as big losses if it isn’t done properly.
In short selling stocks, traders are placed to profit when and if the stock price goes down. This strategy isn’t suitable for long-term investors with the maxim “buy low, sell high.” The point with short selling stocks is to sell high and buy low. For example, when investors believe that the company is overvalued they will sell its stock short.
The strategy is criticized and from time to time meets aversion from company managers, policymakers, and in the public.
Is this strategy legal? Of course, it is absolutely legal.
What is short selling a stock?
Shorting a stock happens when a trader borrows the shares from the broker but under specific conditions. The trader is obliged to return the shares later. The stock can be sold immediately. Short-sellers are betting that the stock price will fall further. If the stock price drops, the trader is in a beneficial position because the trader can repurchase the shares at a lower price and return them to the broker. The difference between these two prices is the trader’s profit.
That’s the beneficial part but there is a risky part too. The problem with short selling stocks may arise when the price rises and continue that because the upward trend increases. That may force short sellers to get out of the trade. It could cause the so-called short squeeze.
If more short-sellers cover their position by buying the stock, the expanded volume can launch the stock price much higher. So, short-sellers will have big losses.
The risk of loss on a short sale is endless because the price of stocks or any other asset can grow to space.
Short selling stocks carries big risks
Short selling stocks can be a very helpful and profitable technique for traders but some circumstances have to be met. Also, it carries big risks. To make this clear, when you buy stocks, in the worst possible scenario, if everything is against you your potential loss cannot go over 100% of your total investment. But your gains are potentially unlimited. On the other side, when shorting stocks your potential losses could be unlimited, but your gains couldn’t go over 100%.
Another warning comes due to the increased costs that you don’t have when buying regular stocks. The first notable cost comes from your broker. So, you’ll have, as a short seller, to pay for borrowing stocks. Your broker will charge you that. That could be extremely expensive. Sometimes, borrowing costs could be bigger than the value of trade, for example, you want to borrow some stock that is especially difficult to borrow.
The other risk comes from the side of a specific account you’ll need to execute the trade. Short selling can be done in margin accounts only, so you’ll need to pay margin interest on your position.
Further, you’ll be a short seller obliged to pay dividends on the borrowed stock. This financial obligation can take a big portion of your gains.
Additional risk comes when you borrow heavily shorted stocks. They are very often subject to buy-in. That appears when the broker covers a short position at the market price but has no obligation to warn you. This situation can happen when the lender, stock owner from whom the stock was borrowed, demands from the broker to return the stock. In this situation, without warning you, the broker will cover your short position at market price even if it is the worst time for you.
How to short a stock?
Of course, we’ll give you a powerful example of how short selling works.
For example, you borrow 100 shares of ABC company that’s trading for $20 per share. That shares are sold very quickly for $2.000 in total.
After, in our example, the stock price drops to $15 per share. Now, you can buy that 100 shares for $1.500 and return them to the lender. Your profit will be $500 minus fees.
As a short seller, you borrow stock from the broker. The broker is one who holds stocks for investors who own a great number of shares. But stocks for short selling aren’t always available because all of them are already borrowed and sold.
On the other hand, some brokers don’t like short selling and rather will stay away from that. They will not participate in it.
How short selling stocks can be a bad thing?
Short-sellers are actually betting that a stock’s price is going to fall soon. But instead of buying, they are borrowing the shares. We explained the whole process above.
Short selling is actually a bet against a stock, but it is not the only way for short selling. For example, if a seller believes the price of a stock will fall, the seller can buy a “put.” That means the seller will by the right, but not the obligation, to sell the stock at a predetermined price at a specific date in the future.
If the price drops below the price accepted in the “put,” the buyer has the right to buy that “put” at this lower price and sell at the “put” price. In this way, the buyer would make a profit. There will be no sales if the price doesn’t drop below the”put” price. The trader who bought this “put” can lose only the amount paid for that, so the whole risk goes to the seller.
Some other bad things related to short selling are not in connection to stocks but maybe, this is the right place to mention them. For example, a trader can buy a “credit default swap.” If the price of the security falls or failure which is possible with bonds, for instance, the buyer of the swap will get the amount equal to the par value of the security. That’s how the short-seller will profit on security drops and, what is more interesting, the short-seller doesn’t need to buy the security, such can buy the “swap” only.
Betting against security in this way is a bit like buying fire insurance on the apartment of a friend but a trader knows that the building is old and not built from a solid material and, also, his friend doesn’t pay too much attention to safety.
Some people don’t like short-sellers because they think that this kind of trading is immoral.
Critics warn against short-selling
Critics of a short-selling claim that it generates unwanted and extreme ups and downs in the stock market which may have a bad influence on the wider economy.
The significant short-selling on the stock of some company has the same impact on the company because it might cause drops of stock’s value and price will drop.
Some investors who started to learn about short-selling probably think the short-sellers know some unusual techniques if they want to make success. So they greatly sell their shares, and what happens? Does the stock price drop? Of course, and the short-sellers are the winners.
Defenders of short selling
They think it is a valuable practice, a technique to force companies to work productively. And it is obvious how they do that. For example, if some company doesn’t work well, the short-sellers will bet against it. Defenders think that short-selling can be stimulative to the companies because it can force the companies to be responsible for their failures.
That’s the exact meaning of the stock market, someone will lose, the others will win.
Short selling can be a true problem when used as “short and distort.” For example, a hedge fund can short the stock of a company and then begin to discredit the performance of the company. If such a campaign causes a decline in the price of the stock, the hedge fund wins but that gain doesn’t come because the company was really weak. This is an example of manipulation.
Short selling stocks is one of the most effective ways to make money when the market is in an extended downtrend. But you must have a deeper knowledge, deeper than it is necessary when buying stocks.
You have to know how to handle risk and keep the chance in your favor. Even before you start shorting stocks. That’s why only really experienced traders can follow this trading technique with success.