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.
- 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..
- 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.
- In short selling, 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.
How Does Short Position in Stock Works?
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 shares 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. (without considering broker commission and other charges)
Short Position in Stock Example
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.
What’s, is the Gross Profit made by the Investor by Performing this Trade?
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.’’’
What is the Maximum Profit that the Investor Earns from this Transaction?
Answer: Maximum profit from a short sell transaction 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
What is the Maximum Loss an Investor would take in Short Selling?
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.
Important Aspects of the Short Position
#1 – Margin Requirements
Short selling typically requires a margin account. In order to execute the trade, you have to maintain enough money and margin to buy back the shares that you 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, you can purchase a stop loss by keeping a margin above the price at which you shorted, so the higher the difference between the stop loss price and shorted price greater the loss the investor would be born.
Advantage of Short Position
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. .
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
- The short position gives the investors to make money not only when stocks go up but also when the stock goes down.
- Short selling will also act as a hedging tool.
Disadvantages of Short Position
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.
- The short position in stocks only fetches money when the price goes down, and if you are 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.
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.
This has been a guide to What is Short Position, and it’s meaning. Here we discuss the examples of how short position in stocks works along with its types, advantages, and disadvantages. You can learn more about excel modeling from the following articles –