How Short Selling Works And Why It’s So Important For Day Traders

short selling

Short selling or shorting stock, is when an investor borrows shares from his or her brokerage firm and immediately sells them, expecting to buy them at a later time when their price falls, return them to the broker and keep the difference as a profit. During the short selling process, the trader never physically owns the shares.

An investor that profits from a stock or the market falling is called a short seller. Such investors also use short selling to hedge the risk of an economic long position in a related security or the same security or to provide liquidity in response to unexpected demand.

Short selling is an odd transaction that isn’t like the normal game plan of first buying shares at a low price and later selling them at a higher price.

How Short Selling Works

Let’s say an investor thinks shares of Company X are overvalued at $30 per share. The investor then borrows 100 shares from his brokerage firm and sells them for $3,000. As time goes by, the price of the shares successfully goes down as the investor had predicted.

At $15 per share, the investor buys 100 shares for $1,500, returns them to his brokerage firm and goes home with a profit of $1,500 less investing costs. But if the price of the stock goes up to $50 share or $5,000 for the 100 shares the investor needs to return, he will incur a loss of $2,000.

Brokerage firms typically use their own inventory to lend stock to short sellers. When buying stock on margin, short sellers pay for part of the purchase and borrow the remaining amount from their brokers.

Short Selling Example

For example, a short seller may buy $7,000 worth of stock in a margin account by paying for $3,500 and borrowing $3,500 from his brokerage firm. Short sellers are responsible for paying the dividend to the firm making the loan if they earn a dividend from the borrowed shares.

Say an investor buys shares for $20 and the price of the shares goes up to $40. If he bought the shares in a cash account and paid for them in full, he is going to walk away with a 50% return on the money he invested.

However, if he bought the shares on a margin account by borrowing $10 from his broker and paying $10 in cash, he will earn a 100% return on his investment. But, he will still owe the brokerage firm $10 plus interest.

Of course, short sellers who use margin accounts are prone to several risks such as substantial losses if the price of the shares sinks.

For example, let us say an investor bought shares at $60 and their price sinks to $30. If the investor fully paid for the stock, he will lose half of his money. But if he bought on margin, he will incur 100% loss plus the interest he owes on the loan.

Margin is not suitable for everyone and traders ought to be aware that they can lose more money than they invested.

In addition, you may be forced to deposit additional securities or cash in your account on short notice in order to cover market losses. Your brokerage firm can also decide to sell some of your securities without having to consult you in order to pay off the loan you owe it.

Some traders short to protect their downside risk if they already own shares of the same stock, while others do it solely for speculation. Short sellers expose themselves to a potentially huge financial risk.

At times, traders and investors attempt to drive up the price of a stock if they see that speculators have shorted a big percentage of its available shares. Speculators with short positions may be forced to cover by buying back the shares before the price skyrockets.

Final Thoughts

Short selling carries more risks than buying stocks, or what is known as going long. When a trader buys shares of a company, he or she obviously hopes they will go up immediately or over a longer time.

When you take a long position, your maximum possible loss is your entire initial investment. But, there is no limit to how much money an investor can lose if he shorts shares of a company and they end up rising.

Stick with long positions for your investments, unless you’re a short seller who is sufficiently skilled to play the game. Don’t always follow suit every time a professional investor announces a short position.

Professional short sellers can be helpful to other traders, but you also need to at least do additional research on your own to be on the safe side.