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Short Selling Stocks Explained

Short selling stocks is a trading strategy that sees investors profit from the decline in the value of a stock, or any other security. It is a complex strategy, which should only be executed by the most experienced investors.

The trading strategy is generally used as either speculation or as a tool for hedging against risks that could have a downward effect on long positions in the same market. Used as speculation, short selling comes with large risks and is a highly advanced method of trading. Hedging, however, lacks these risks and simply involved offsetting a position in order to minimize exposure to risk.

A positioned is opened in short selling by lending shares in a stock, or asset, that an investor thinks is likely to go down in value within a certain period of time, the position’s expiration date. The borrowed shares are then sold on the market. Before these borrowed shares must be returned back to the original lender, the investor is betting that their value is likely to decrease so that they can be re-bought at a lower price. In theory the amount of loss an investor can make on this type of trade in unlimited, as the price of a stock, or other asset can increase as much as the market determines.

How does short selling work?

An investor opens a short position by lending shares in the desired stock from a broker in the hope of using them to profit before having to return them back to that broker.

To open this type of position an investor requires a margin account. On any position they have open, an investor will have to pay an amount of interest that is based on the value of the shares that they have borrowed. As a result of the regulations and rules set by the United States Financial Industry Regulatory Authority, the Federal Reserve, and the New York Stock Exchange an investor’s margin account must hold a minimum amount of equity in it.

This is referred to as the margin maintenance and is equal to 25 percent of the total value of an investor’s securities. If the level of equity within a margin account goes below this then an investor is required to put in more equity or the brokerage firm can force a sale of the position.

Courtesy of The Balance

An investor closes a short position by buying the shares that they initially sold back. It is hoped that this is at a value that is less than what they were sold for. The shares are then given back to the broker. Investors must take into account the interest charges made by the broker. This is because they charge for their services of locating shares within the desired stock that can be borrowed. It is also the broker that returns the shares to the lender come the end of the trade.

As previously mentioned, one of the main reasons for partaking in the short selling of stocks is to speculate. The traditional trading strategy of going long can either be classed as speculation or investment. This is dependent on two single factors; the amount of risk in the trade, and the time over which the trade takes place.

An investment based strategy has less risk associated with it but occurs over a longer amount of time. A speculative based strategy is much more high risk and takes place over a much shorter amount of time. 

In the value investing community, short selling is not usually recommended, since we strive to limit our speculation and stick to investments that we know and understand. 

How to profit from short selling

It is best to show this via the use of an example. An investor thinks that the value of XXX stock will decline from its current trading price of $50 in the next couple of months. Because of this belief the investor borrows 1,000 shares of the stock and sell them on to another investor. The investor is now in a short position as they sold shares that they did not own. Some time later, XXX company announces upcoming losses for the next financial year, and so the value of their stock falls to $40.

At this point the investor decides to close their position and buys back those 1,000 shares at $40 each. The amount of profit the investor makes from this trade, not including the broker’s commission and any margin account interest, is $50,000 (the price the shares were originally sold for) – $40,000 (the price the shares were bought back for) = $10,000 (the difference between the price the shares were sold for and the price they were bought back for).

Albeit very risky, this is exactly how Dr. Michael Burry made a fortune in the movie The Big Short.

How can short selling be risky?

An investor that holds a short position can potentially lose much more than just their original investment stake. This level of risk is present because there is no limit to the value of a stock. In theory it can rise to infinity. Also holding stocks means that having to fund a margin account. Even if all of an investors trades go well, they must still consider the interest charges generated by their margin account when working out what their profit is.

There is also the very real problem of an investor that is short selling struggling to find enough of a certain stock’s shares to buy. This is particularly true if lots of other investors are also short selling that stock or if it is traded thinly. Investors short selling can also get short squeezed if the price of a stock begins to rapidly increase. Other risks associated with short selling stocks include investors getting their timing wrong, running foul or the various rules and regulations, and going against the trend.

How to master the strategy of short selling?

Short selling is only recommended for very advanced investors, as it requires a lot of time, research, and analysis. There are lots of online resources available to help you with this. If you invest some time in yourself to develop the skills required you will be investing in short selling stocks in no time, and profiting massively. Learn more of it by checking out TimothySykes.com.