Key points
- Shorting a stock is selling a stock to speculate on its price decline.
- Speculators go short when they expect that the asset will depreciate.
- A short trader loses money if the shares rise in price.
- Short positions are always secured by a margin.
- Short positions are typically opened either for speculative or hedging purposes.
What does Shorting a Stock Mean?
Shorting a stock is a form of speculation in the stock market. “To short” in financial terms means “to sell”. Traders use this strategy when they think that the stock is going to fall in price. The whole process consists of four steps:
- 1. Borrowing an asset;
- 2. Selling it at a high price;
- 3. Buying it once the price drops;
- 4. Returning the asset to the lender.
The profit of a trader makes the difference between the selling price and the buying price.
Example of Shorting a Stock
How to Short a Stock?
To borrow a stock, a trader needs to register with a broker. Although the trader doesn’t intend to buy the shares, he/she is required to open a special margin account and deposit a certain amount of money (typically 50% of the price). The deposit money is called maintenance margin that serves as collateral in the event the investment loses value. If the price of the asset moves against the trader’s expectations and rises, it will be eating away the maintenance margin before the trader receives a margin call. A margin call is a notification saying a trader’s margin deposit becomes insufficient and the cash buffer should be increased or the trade will be closed.
What Are the Risks?
It is clear from our example that the main risk of a short position is that the price of a stock can rise instead of falling. What’s important to understand is that there is no limit to which the price can grow and subsequently the amount of money a short seller can lose. Buying a $200 share exposes an investor to the risk of losing no more than $200 because there is no chance the stock price falls below 0. Selling a borrowed asset at the same price may lead to much larger losses, as the asset may rise in price to endless heights.
One can lose money when shorting a stock even if the price of the stock remains unchanged. Brokers lend stocks because they profit from loan commission. Thus, if you intend to borrow a company’s shares, be aware of interest rates, same as if you were borrowing money from a bank. Typically the interest rate on a short position ranges from 2,5 to 20% of the asset’s price, or even higher for volatile or small-cap stocks.
Speculation vs. Hedging
There are two reasons for opening a short position. They are speculation and hedging. As it was explained in the example above, speculation involves capitalizing on a possible decline of an asset. Hedging, on the other hand, is meant to limit the risks associated with another strategy. This is why short-selling is particularly popular among hedge funds that use short positions in certain sectors or stocks in order to hedge their long positions in other sectors or stocks.
Should I Start Short Selling?
If you see yourself as a long-term investor, short-selling stocks might not be interesting for you. Stock prices are constantly fluctuating, which doesn’t make investors sell them if they believe the price will grow in the longer term. But in terms of speculation, the short-selling strategy might be interesting for people who have that trader’s mentality and a good understanding of the market. If you are good at predicting price movements and ready to devote time to trading, this strategy might suit you.
Conclusions
Short selling stocks is a strategy that may work well for hedging or speculative purposes. It involves selling a stock at a higher price to buy it back at a lower price. The difference between the selling and buying prices makes a trader’s profit. The same amount of money plus the broker’s commission can be lost if the price moves against the predicted direction. Offering a high risk/reward ratio, short selling attracts the attention of traders rather than long-term investors.
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