SHORT SELLING: KNOW THE BASICS

By Rozzie Dondi, Financial Consultant

January, 31st 2020.

Introduction

In stock trading, the traditional way to earn a profit is to purchase low then sell high, but when one wishes to sell short, they do the reverse. Short-Selling is a trading strategy or investment, which speculates on the price decline of a stock or other security. It is a concept where a trader borrows from a broker a stock, makes a sale on it, and then purchases back the stock and gives it back to the lender. Experienced investors or traders should undertake it as it is an advanced strategy. Short-sellers bet that there will be a price drop in the stock they sell, allowing them to repurchase it at a reduced price before returning the capital to the lender. This discussion explores aspects of shorting, how it works, the risks involved, and the benefits of the investment strategy.

How Short-Selling Works

The seller in short-selling opens a position when he borrows from his dealers' shares in an attempt to profit. A trader who opens a short position must have a margin account and is mandated to pay interest on the borrowed shares’ value while the position is open. A maintenance value refers to the set amount by the Federal Reserve which the margin account needs to maintain as its minimum values. The broker may sell the position when the account value of the investor drops beneath the maintenance margin, or the investor will need to inject more funds to keep his position. The short position is closed when the trader purchases back on the market the shares, hopefully at a value lower than that of the borrowed asset, and gives them back to the broker. The commissions incurred on trades or interest charged by the lender must be accounted for by the traders or investors. Brokers often handle behind the scenes the process of selecting securities to be borrowed and at the end of trade returned. The closing and opening of the trade can be made through regular platforms.

For instance, when a short-selling investor seeks to invest in stock A, with the overvalued stock at $415 per share. With a perceived fall in price, he or she may borrow from their broker 10 shares of Stock A, and at the present market price of $415, sell the shares. The investor could purchase the 10 shares if the stock falls to $400 at this price, making a net income of $ 15 per share ($415- $400) and return the broker the borrowed shares. However, suppose Stock A’s values increases to $455, the investor incurs $415-$455= -$40 loss per share.

Risks Involved in Going Short

The investment strategy is costly when the seller makes wrong calculations about the price movement. In case the stock moves to zero, a trader who purchased stock only loses 100% of their investment, but in shorted stock, the investor risks more than 100% of the outlay investment. The reason for the infinite loss is because there is no ceiling for the value of the stock, and it can increase to infinity and beyond. Conversely, when a given stock or the market begins to skyrocket, sellers risk getting entangled in a short squeeze loop.

Also, the cost of margin interest has to be factored in when the traders calculate their profits when all goes well. In cases where the security is thinly traded, or several other traders are also going short, a short seller may find it hard to purchase adequate shares when it is time to close a position.

 Going short involves an amplified risk because the losses are unlimited theoretically. In case an investor goes long or purchases a stock, they may lose the amount invested as $0 is the minimum value any stock can drop. Therefore, when an investor invests $415 in one Stock A share, they can lose $415 as the maximum amount given no stock can fall below $0. However, an investor can lose an infinite amount invested theoretically when he or she sells short, and the value of the stock keeps increasing forever. For instance, in the above case, if an investor short sole or had a short position in Stock A and before he exits, the rise shoots to $455, the amount lost per share would be $40.

 Why Sell Short?

Shorting can be used for hedging or speculation. Hedgers go short of mitigating losses or protecting gains in portfolio or security. Speculators utilize the short-selling strategy to capitalize on the potential fall in the broad market or given security. Among the most active short-sellers are hedge funds, which utilize short positions in hand-picked sectors or stocks to hedge their long positions in other securities. In a neutral or declining market, short selling offers investors a profit-making prospect. Given the tremendous loss risk, advanced investors and sophisticated traders are the only ones.

Selling short is a high-yield reward given the high risks involved. With an accurate prediction on price movement, the seller can make a massive return on investment (ROI), basically when they initiate the trade using margin. Margin, when used, offers leverage; hence, the trader does not require to invest substantial capital amounts as an initial investment. Short-selling, when carefully executed, is an affordable way to hedge and offers a counterbalance to other portfolio holdings.

In the long run, the securities market tends to go up, but there are periods when the value of stocks declines. The stock purchase is less risky for investors seeking a long horizon than short-selling the market. The strategy is sensible when a trader is sure of the possibility of a decline of the stock value in the short term, like for companies or firms undergoing difficulties.

 Conclusion

Shorting is a complex strategy with high rewards when well speculated and predicted because it offers the investor vast amounts of ROI. However, it needs accurate timing or the risks can be high, and the losses infinite. It uses borrowed money to invest, and the interests incurred in case of a loss can be unlimited. Given its advanced nature, it requires well-experienced investors and traders.