If you hear people saying "going short" or "shorting a stock", you can be 100% sure they are discussing the short selling. The concept has become extremely popular with traders. It reserves more space for manoeuvre, while investors have access to a wider set of trading instruments.
What's Short Selling?
How the Short Sale Process Works
Real-Life Short Selling Precedents
Core Short-Selling Advantages
Short-Selling Example
How to Start Short Selling with Margin Account
Conclusion: Is Short Selling Good or Bad?
When a trader is "going short" or "shorts", he trades different assets. They may include stocks, currencies or goods. The main idea of the short selling concept is that a trader actually does not own any of those assets during the transaction.
How is it possible? How can one sell something he does not own? Here we have a form of short-term assets borrowing followed by their selling impulsively. You should clearly understand that borrowing is not free. Traders are usually charged borrowing fees and interest rates for using the asset.
The next stage is to predict the asset price in the short run. If price decreases, they return investment by buying the asset back at a lower price, and pocket the difference. Sounds pretty easy, right? Well, the concept comes with some obvious risks and the need for the in-depth market analysis, foreseeing, and price predictions.
So, what is the fuzz all about? What does it mean to short a stock? The idea is very simple: you make money on selling stocks that are about to drop down in price.
The concept itself consists of several baseline stages. They are as follows:
Step 1 – borrowing a stock. As an investor, you find a broker to chose a stock that is about to fall down and borrow it.
Step 2 – selling a stock. You sell the stock and wait.
Step 3 – bringing the stock back. The last phase is to bring the stock back to the lender at the lowest price tag, and make the difference.
A great tool to let you grab your piece of a cake! While the financial market is under pressure, short selling stocks deliver maximum flexibility. It will fit both professional and novice traders.
Let's have a look at how the concept works under real market conditions. The following stages are to clarify how you may sell stocks or other assets and go short:
Phase 1
A trader turns to a broker with the aim of borrowing an asset (a stock, currency, product, etc.). He does not own the asset but is still able to trade it. Let's say, the asset price is currently 100 USD.
Phase 2
At the next stage, a trader sells the asset at 100 USD and then waits until the price drops down. If the predictions are correct, and the price goes down to 45 USD, a trader buys it back and makes the 55 USD difference to pocket.
Phase 3
A trader gives the asset back to a broker. The real profit might be a bit lower, as a trader still needs to repay broker commissions and interest rates for borrowing the asset. The price tag varies from broker to broker.
To sum it up: short selling is a type of deal, where a trader sells an asset that he does not own. The standard motivation for short selling is the assumption that the asset's market value will decline. When the opened position is covered, the borrowed asset has to be returned.
The concept works great with various trading strategies. You may use it when hedging or speculating, hedgers may benefit from mitigated losses. Speculators get a chance to make a profit on the potential decline.
As a result, going short still involves some obvious risks. On the other hand, the following benefits make the concept worth trying:
To see all the benefits with your own eyes, let's have a look at a short-selling example.
While crude oil is one of the most popular instruments, we are going to use it for our real-life example. So, the market opens with a price of $45 per barrel. If you use a regular trading concept, you would probably open a position as a buyer and make the difference on every price increase.
Short selling lets you not only open buying positions but also act as a seller. If you are sure that the price is about to drop down, you immediately open a selling position. If the price falls down to $44.50, you make $0.50 for every unit sold.
As a speculating trading concept, short selling requires funds traders usually do not have. Traders, who opt for this particular strategy, generally need to open a margin account. It connects brokers and traders letting first lend assets at a fixed interest rate.
Both parties have a short-term agreement with the core obligations and responsibilities described in detail. Following those obligations is vital. Violating the agreement may result in loan disclosure. For traders, it means being left without the asset to sell.
"...Seems complicated and risky. Why do people use margin accounts?"
Going long seems to be less risky if compared with the short-selling strategy. A trader can only lose the money spent on the asset purchase. The situation is quite different when going short. In theory, the potential loss can be unlimited or restricted by a margin call. The margin call is a highly negative outcome for a trader.
So, you have opened a margin account. Now you can borrow from your broker. But once your balance drops down below the maintenance amount, the margin calls occur. In this case, a broker demands adding needed funds or close running positions and contracts. If a trader ignores the call, the brokerage party has a right to close any position to have the minimum value backed up.
The main downside here is that a trader is the only personally responsible for potential losses when going short. So, it is very important to keep up with the funds to prevent your shares from liquidation.
Short selling can really work. It helps to potentially rap an enormous return in the short run. Moreover, traders are not forced to put huge sums upfront. Broker fees and borrowing commissions are the only costs considered when going short.
Besides, it can be used as one of the few trading instruments. A good idea is to combine the concept with other strategies without having your back against the wall when things go out of hand. Never put all eggs in one basket.
Our verdict: short selling is certainly worth trying.
Ready to learn more about short selling? Read about the Big Short movie in our digest of 7 Best Trading Movies to see how it works in real life!
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
