Short selling, like other forms of high-risk investments, is a popular trading strategy. Shorting a stock is the opposite of traditional investing or going long and is popular, especially for those with some experience investing. In this article, we will discuss short selling and when shorting a stock might be a good idea.
How Short Selling Works
Understanding how to short a stock may seem simple, however there are a lot of factors to consider. A trader first borrows shares of a stock and sells them on the open market. When the price drops, the idea is to buy back the shares and pocket the difference. The amount of short orders outstanding is what we call short interest. The risk comes when short sellers sell the asset before they even own it, hoping that the profit could be generated from the downward price movement. On the other hand, traditional investors spend their money to acquire the actual asset, which is then sold to make a profit if the price goes on an ascending trend.
All traders who want to short sell need to have a margin account. With this type of trading account, brokers lend traders cash or securities. Keep in mind that each broker and company’s requirements for opening margin accounts vary. In addition, traders must have sufficient cash reserves to borrow the security they wish to short because trading comes with high risk of losing capital.
Once they have opened an account, traders open short positions to speculate on their belief that the price of an asset will fall. This allows them to invest in assets that they believe will depreciate in value. It also allows them to make money on stocks they are not in a position to actually obtain.
When to Use Short Selling
Short selling is a trading strategy that tends to be used by traders who believe that the price of an asset will drop. It is a risky option as since prices can theoretically rise to any level, the commitment to buy back is unlimited. For this reason, short sellers usually open stop orders, which are performed when a stock price reaches a certain level, thus limiting the trader’s losses. Short selling is usually considered whenever a trader anticipates that the price of an asset will fall, for instance, in the face of negative news, such as lower-than-expected earnings etc. Short positions can benefit a diverse portfolio and support various trading strategies.
For example, a trader believes that ABC Inc is overvalued at $500 per share. They would then borrow 100 shares from their stockbroker, opening a $50,000 short position. If that stockbroker’s holding requirement for ABC was 75%, this would equate to holding $37,500 in an account. The trader could sell those shares on the open market, collecting $50,000. If the stock dropped to $300, the trader could buy it back for $30,000 and make a profit of $20,000. However, if the shares went up $200 instead of down, the stockbroker could issue a margin call, requiring an injection of cash into the account and meaning a loss.
Risks Associated with Short Selling
In terms of risk, traditional investors only stand to lose their initial investment, for example, if the stock price falls to lowest values. On the other hand, short traders risk losing potentially unlimited amounts of money because a stock price can rise to any level. Because short trades involve borrowed securities, they are subject to higher costs than other forms of trading. These include margin fees, borrowing costs, and costs associated with dividends and other financial events. Many regulators have a low opinion of short selling, believing traders worsen negative price drops and engage in manipulation. During economic crises, it is not uncommon for short trading to be restricted for a period of time. Another risk is that stock prices don’t always go down when we want them to. If a trader speculates that a company’s stock price will fall, and it then defies expectations and continues to go up, the short position has suffered a loss.
GameStop and Sky Harbour Group are some of the most high-profile cases of a stock being shorted on a big scale. The incident with GameStop has become one of the most infamous situations where investors saw a struggling stock and started short-selling it in order to make a profit, under the belief that the price was sure to drop. However, this backfired when a group of Reddit users collected together in order to push the share price up, from $4 a share to above $300, meaning massive losses for short sellers.
There are certain situations, however, where short selling is justifiable. For example, if there is good reason to believe that an asset will decline or the general economy does not support the stock markets. Short selling offers many potential benefits, including its flexibility and inclusivity. Traditional investors are by definition 100% bullish, gaining in good times and losing in bad times. Whereas short selling allows investors to hedge their risk. It will enable them to gain some downside exposure to specific companies and sectors or the overall market.
Conclusion
Short selling is a strategy that can be utilized in times of economic downturn to generate potential earnings. It is vital to understand the significant risks involved in short selling and cover them adequately with stop-limit orders and by using a reputable trading platform. Start by opening a demo account to gain some experience without the risks. Once you’re ready to trade, ensure you’ve research the market you’re ready to trade in. Making use of stop losses can also help to mitigate yourself from large losses.
Disclaimer:
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
Marketing for CFDs and spread betting is not intended for US citizens as prohibited under US regulation.
