Short Position

What Is A Short Position?

A short position is a practice where an investor sells a stock that he/ she doesn’t own at the time of selling; the investor does so by borrowing the stock from some other investor on the promise that the former will return the stock to the latter on a later date.

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A short position is a good strategy for an investor who knows the risk and reward of the strategy well. By the very nature of this strategy, the investor is trying to capitalize on those type of information which is not easily available in the market and definitely not in line with the consensus opinion.

How Does Short Position Work?

A short position in stock is a trading strategy where the investor borrows  financial asset from the broker and sells it in the market with the hope that the price of the asset will fall in future. In this process, the investor aims to earn profit from the bearish sentiments of the market.

By doing so, the position the former investor takes is called a short position, and the process of selling the stock is short sellingShort SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more.

He sells the stock by borrowing it on the hope that the price of these shares will decline, and he will make a profit by buying back those shares on a later date at a lesser price. After buying the financial asset at a lower price later, the investor has to return it back to the broker because it is a borrowed asset. The investor was not the original owner of it.  

In short position trading, the maximum profit the person who takes the short position can make is the difference between the price of the stock at which the short-selling has done and zero. In that way, the maximum profit the investor can make from a short-selling is certain. Whereas the maximum possible loss that can happen from a short-selling trade is unknown beforehand.

Examples

Let us try to understand the concept of short position trading with the help of some suitable examples.

Example#1

Let’s assume a stock is currently trading at $90/ share in the market. An Investor anticipates the price of this stock will fall to $35 -30/share in the coming months and has decided to short sell 5000 stocks.

Let’s assume he short sells as per his plan and bout back the share @ $32/ share after three weeks.

Gross profit that he made from this trade is 5000* (90-32) =5000*$58 = $ 290,000

So the investor has made a gross profit of $290,000 by borrowing a stock that he doesn’t own. Maximum profit from a short position in stock equals to the price at which the stock shorted minus zero multiplied to the number of stocks shorted. So, in this case Maximum profit = (90-0) *5000 = $450,000

The loss that can happen to an investor in short selling is infinite. This is because any potential stocks upside is unlimited, so if the stock price keeps increasing after shorting the stock and if the investor does not have taken enough measures to hedge the loss, the loss can be infinite.

Example#2

Investor one wants to short sell 5000 quantity of a particular stock, let’s say stock A that trades at $90

Step 1: He places an order to short sell the stock with his broker

Step 2: Broker arranged the number of shares and executed the trade on behalf of the investor, and proceeds would be credited to the investor’s margin account. Most of the time, the investor has to also keep a margin deposit in the account. Let’s say, in this case, it is 50%.

Then post-execution of trade, the Investors margin account would have a total of 90*5000 + 50% of the transaction value

= 450,000 + 225,000 = $675,000

Let’s say after a month the stock A is trading at $32, and the investor then decides to buy back the shares. Buyback of sharesBuyback Of SharesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more will result in a cash outflow of 5000*32= $160,000.

So from this transaction, the investor has made close to (450,000 – 160,000) $290,000 gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more (without considering broker commission and other charges), from the net short position.

How To Take A Short Position?

In order to take a short position, the trader or the investor has to follow a few steps that are elaborated in details below:

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#1 – Margin Requirements

Short selling typically requires a margin account. In order to execute the trade, we have to maintain enough money and margin to buy back the shares that are shorted. For example, 150% of the envisaged transaction.

#2 – Hedging Instruments

As we mentioned earlier, the potential loss from a short sell transaction is infinite. So, generally, the investor hedges his position to minimize the loss. I.e., while shorting a stock, one can purchase a stop loss by keeping a margin above the price at which the stocks are shorted, so the higher the difference between the stop loss price and shorted price greater the loss the investor would be born.

It is to be noted that this process is subject to some special regulations. Therefore it may not be permitted or available for execution in any financial market. It may also not be allowed under some special situations of the market. The process also involves payment of fees or borrowing cost because the investor has to borrow and thus compensate the lender for lending the financial security for trading purpose.

How To Cover?

Covering a short position is the process of repurchasing the asset after short sale, which can also be called as closing the net short position. The steps to do it are as follows:

• It is necessary to understand and identify the current merket price of the asset that was shorted. This will help in deciding when to cover the position.
• Next step is to place the buy order with the broker to buy back the stock at a lower price.
• Once the buy order is placed, it will be executed at the prevailing market price. Thus, the asset is purchased to close the position.
• Next step is to check whether the asset has been credited to the trading account correctly. If it is done, the transaction is confirmed.
• The following step is to return the asset back to the lender or the broker because the investor has borrowed it.
• Now the investor will calculate the gain or loss from the entire process. If the price at which the asset is bought back is lower than the price at which they were sold, the investor earns profit.

The above steps summarise the entire process of covering a short position.

Advantage

Short selling is beneficial for the capital market in many ways. It provides liquidity; it helps to correct the overvalued stocksOvervalued StocksOvervalued Stocks refer to stocks having more current market value than their real earning potential or the P/E Ratio. Overvaluation of stocks might occur due to illogical decision making or deterioration in a Company’s financial health. read more.

Proponents of short selling claim that short selling practice improve the efficiency of the market and it deters promoters of the company from doing activities to manipulate the stock prices

• Taking a short position gives the investors the opportunity to make money not only when stocks go up but also when the stock goes down.
• Short selling will also act as a hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more tool.
• It also helps in diversification because by adopting both short long positions, the investor gets the opportunity to gain from different market conditions.
• It gives a chance to make anticipation and capitalize during falling market or gain from assets that are overvalued.

Disadvantages

Critics of short position claim that directly or indirectly, short selling can create deliberate volatility in the capital market. It can exacerbate a downtrend in the capital market and can take the individual stock prices to the level which otherwise would not be. It can pay way to manipulative trading strategies.

• Taking a short position in stocks only fetches money when the price goes down, and if the investor is wrong about the prediction of the price movement, then the loss is potentially limitless.
• A short position is sometimes detrimental to the capital market; also, if a group of people decided to short a stock, then that particular company may go bankrupt also.
• There is borrowing cost or fees involved because the investor is borrowing the asset from the broker. Thus, takes away some of the profit.
• It requires a lot of analysis and understanding of the market to confidently take a short the stock. If the price does not fall, it leads to losses.
• The investor needs to follow some strict regulatory requirements for the process.

Short Position Vs Long Position

The two financial terms given above are two different strategies or approaches that investors take in the financial market to earn profit from their investments. Let us lokk at the differences between them in details.

• The former refers to the position that investors take when they anticipate a fall in the price of the asset whereas the latter is a position for anticipation of rise in price.
• In the former process, the investor does not actually own the financial instrument but in case of the latter, the investor actually owns the asset.
• The investor eventually buys back the stocks in case of the former, but the investor, in the latter case, already has the stock which they plan to sell later at a higher price.
• The former is associated with bearish sentiments whereas the latter is associated with bullish sentiments.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to what is a Short Position. We explain its differences with long position with examples, how to cover & how to take the position. You can learn more about excel modeling from the following articles –

• Short Sale of Stock Works
• Short Sale vs. Foreclosure
• What is Financial Market?
• Money Market vs. Capital Market