What Is Short Selling? How can you gain from it?

advertisement

Shorting a stock is an investing technique where the short seller predicts that the value of the stock will fall. An investor who goes short buys a stock he expects to depreciate, sells it at the market price, and buys it back at a lower price. The investor completes the short sale by returning the stock to the lender and profiting from the difference. Short selling is a stock trading method used for short-term trading of stocks. Investors can make a lot of money when the stock price goes down, but they can lose a lot of money if the price goes up.

How does it work?

Short sellers first borrow stock from a broker. They then sell the borrowed shares at market value and deposit the proceeds into their accounts. Short sellers decide whether to go short by repurchasing the exact amount of shares they sold to repay lenders borrowed shares. Short sellers wait for the share price to drop to buy back at a cheaper price and take advantage of the difference.

If the stock price goes up, the short seller loses the trade and he buys back the stock at a higher price. If the stock price rises, brokers can issue a margin call, forcing short sellers to add additional funds to their brokerage accounts, or to close the trade by buying back the stock at the current price. Short sellers may think the stock price will fall, but they risk losing more money because they will eventually have to pay back their lenders.

What are the benefits of short selling?

Short selling can be done for a variety of purposes, including hedging and speculation.

Speculation: Speculators short stocks they believe are overvalued to profit from declines. Speculative short selling is a high-risk investing technique.

Hedging: Most short sellers are hedgers. Many hedge funds use hedging as an investment technique. Hedgers short stocks to reduce risk in other long-term investments. Rather than profit from short selling, hedgers try to limit potential losses or lock in gains on other long-term assets.

Short selling risk

While shorting stocks has the potential to generate huge profits, there are a number of issues to be aware of:

Unlimited loss

When you go short a stock, you can lose a lot of money if the stock goes up forever, and instead of going long, you only lose the money you invested.

Additional charges

Short selling a stock is much more expensive than trading a regular stock. To borrow money from a broker, you must first create a margin account, which usually has a minimum margin requirement. If the funds in your brokerage account fall below the required margin, your brokerage will issue a margin call. Additionally, when trading stocks on margin, you must pay interest costs that accrue over time until you repay the borrowed stocks. Finally, depending on the company's price and availability, stocks with substantial short interest may incur additional hard-to-borrow (HTB) bond penalties.

Trade restrictions

Wall Street regulators, such as the Securities and Exchange Commission, have the power to limit who can sell shorts and when. When the stock market experiences a sharp drop in stock value, you can implement a short-selling ban to avoid panic.

Possibility of short-term squeeze

A short squeeze is an investment phenomenon that occurs when the value of a short stock increases dramatically. The short squeeze forced many short sellers to cut losses by buying back shares before they rose. Buying stocks raises the price of the shorted stock, causing more short sellers to buy back the stock, again increasing the value of the stock.

(Writer:Charles Ouko)