What is Short Selling?
Short selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security and 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. The interesting part of this phenomenon is that a trader can sell a stock or an asset even if he does not own it in his portfolio. It is mostly done on financial instruments trading in financial markets, commodities, and currency markets.
How to Short Sell a Stock? (Steps)
The mechanism of short selling involves three basic steps:
- Step 1 – You borrow shares from your broker by paying a small fee. The broker can arrange these shares by contacting large institutions.
- Step 2 – Now, once the broker has arranged the shares in your account, you can sell them at the current market price on the anticipation that the market price will fall and then buy them at a lower price.
- Step 3 – The last step in this process is buying back the shares once the target price is achieved. Now If the price has moved in the direction, you predicted then you have made a profit else you will have to buy back shares at a higher price, eventually leading to a loss.
- Step 4 – The trader returns the stock to the broker.
Example of Short Selling Stocks
Let’s take the example of short selling.
Consider a scenario where a stock is trading at $500. The quarterly results are awaited in a week, and looking at the competitor results, it looks probable that the firm will post bad numbers. A trader wants to utilize this opportunity and earn by short selling this stock. Since the trader does not own this stock, he would have to borrow these stocks from his broker. Post this, and the trader short sells the stock anticipating the stock price will go down. The plan is that the trader will buy back the stock once it has fallen by 10%.
The quarterly results declared one week later are on expected lines, and the firm has posted a fall of 10% in profit on a yearly basis. The stock prices crash and stock declines by 15%. The trader seeks this opportunity and, maintaining financial discipline, close his positions at $450, 10% down from the market price of the last week. The trader has made a profit of $50 (10%) on each lot. Assuming the contract was for ten lots, it leads to a profit of $500 on an investment of $5000.
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Calculation of Annual Return will be –
The scenario just discussed was a favorable scenario when the stock price moved in the anticipated direction, and the trader has made an annualized return of 520%. No assets in the world can give that return. However, on the contrary, if the firm had posted good results, the stock price might have boomed, and the traders’ position would have worsened. The results are summarized below.
Calculation of Annual Return will be –
Advantages of Short Selling Stocks
Some advantages are as follows:
- Short selling of stocks is a unique feature that allows a trader to take positions on financial products that he might not own but still profit from them by predicting their falling prices.
- Short selling is often done on margin and involves good leverage. Hence, any trading position, if predicted correctly, can lead to magnified returns.
Disadvantages of Short Selling
Some disadvantages are as follows:
- The biggest disadvantage of short selling is the money that a trader can lose if the price moves in the opposite direction. Since the maximum price that can go while going down is zero, there is no upper cap to the price. So on a bad day, if you land on the other side, it can lead to huge losses.
- Another disadvantage is the cash flow associated with the underlying financial product. If the trader has short-sold stock for some time and it pays out dividends, then, in that case, the trader is liable to pay that dividend to the broker.
- Short selling is used by big institutions for hedging purposes. Big corporates who are dependent on commodities whose prices might fluctuate in the future use short selling to hedge their risk. For example, tata motors have huge exposure to the UK market. Hence to hedge the risk of the great Britain pound going down, they will short sell GBP futures contracts to minimize any adverse movement of the underlying.
- Short selling is the only mechanism through which money can be made in the falling market or recession periods. Also, the leverage short selling provides is much better than buying the underlying product. That’s why it’s a common saying in financial markets that more money is made by selling than buying.
- Short sell is basically a short-term strategy. In general, if you look for long-term stock markets across the economies of the world, tend to go up. To consistently make money, the trader has to time the market correctly and be cautious of closing out the positions on a bad day.
- Short sellers though a try to make a call based on the events (like quarterly release declaration) or bad news, but most often than not, the news is already priced at the current market price. At that moment, you might find the price appreciating after some time, even though everything about the stock looks bad. In this scenario, even after doing every research, the short-seller might lose money.
Although it may sound speculative, short selling is one of the hedging strategies employed by not only hedge funds or institutional investors but also big corporates. It avoids the hassles of selling the underlying in case the cycle has shifted, and the situation looks grim for a short duration of time. Simply put, in such a scenario, investors can hedge their positions by short selling rather than selling their delivery positions.
This has been a guide to what is Short Selling, and it’s meaning. Here we discuss how to short sell stocks along with examples, advantages, and disadvantages. You can learn more about derivatives from the following articles –