The Basics Of Short Selling Stocks
‘Shorting’ or short selling refers to the selling of a contract, a bond or stock or a commodity that is not directly owned by the seller. When practicing short selling, a seller is committed to purchase the stock or commodity previously sold.
Short selling stocks means to take the stock from a broker on loan and sell it off to someone else. This is done so that the seller buys back the stock, when the price falls. The shares are returned to the broker from whom they were initially borrowed. The shorting profit or the difference in price goes to the seller. Short selling of stocks is a technique used by investors to capitalize on a probable decline in the stock price.
To understand this better, let us consider a company, say, ABC whose shares currently sell at $12 each. A short seller borrows 50 shares of ABC and then sells those shares to someone else at $12 per share, for a total of $600. Now, if in future the price of shares of ABC falls to $10 per share, this short seller would then buy back those 50 shares at $500 ($10 multiplied by 50 shares), send back the shares to the original owner/broker and make a profit of $100.
Short selling is risky, if the price per share goes up instead of declining, as expected. Suppose the price per share of ABC goes up to $15 per share, then the short seller will have to cash in the previously sold 50 shares at $750, return the shares to the original owner and incur a loss of $150.
Shorting is a transaction done on margin. Most brokers do not agree to short selling stocks below $5. This enables the investors and short sellers to indulge in the high-risk trading of stocks.
Some of the following market situations help to predict a fall in price of stocks: –
– Market indexes coming near the prior resistance levels.
– Market trend showing technically overbought levels.
– Restlessness before the announcement of a state’s government.
– Market vulnerability during scandals.
Large volume selling of stocks often result in short-term high profits. However, there are certain guidelines to be followed for successful short selling. They are:
– All stocks are not ‘short’ able. Generally, brokers inform a seller whether a stock can be used for short selling or not.
– Sellers must open a margin account for short selling. This depends on the minimum balances and cash reserves. Sellers are required to sign a contract agreement with the brokers to open a margin account. This agreement clearly states that a seller will follow the rules and regulations stated by the broker.
-Target bad-performance, overpriced companies, since the probability of a fall in the share price involves lesser risk.
– Traders and short sellers should use stop orders to protect their capital from loss. Generally, brokers prevent a seller from suffering loss more than the principal. They may either compel the seller to quit the transaction or they may deposit funds to increase the seller’s capital.
The short selling of stocks involves a lot of discipline. Sellers need to be proactive, alert and disciplined when shorting stocks.
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Stephen Romero - November 22, 2022
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