You cannot simply set foot in the stock market without a trading strategy. A good trading strategy is every stock market trader’s holy grail. One such go-to strategy for today’s stock market traders is short selling. So, what exactly is short selling, how does it work, and what are the risks and rewards of short selling? Let’s find out in this post.
What is Short Selling?
Short selling is a strategy for trading that involves investors speculating on a stock’s price drop. Short sellers bet on and make a profit through a drop in a security’s price.
Traders typically use this strategy as speculation, and investors or portfolio managers would use it as a hedge against the downside risk of a long position.
How Does Short Selling Actually Work?
Traders would usually engage in short selling for speculation and hedging. In order to open a short position, a trader needs to have a margin account and pay interest on the value of the borrowed shares when the position is open.
A broker would handle locating shares that could be borrowed and returning them at the end of the trade. Opening and closing the trade could be done through ordinary trading platforms where brokers are qualified to perform margin trading.
How Does One Short Sell?
You will need to follow some steps in order to short sell, and they are listed below for you:
- A seller opens a short position by borrowing shares. It is typically from a broker-dealer while hoping to re-buy them with a profit from the price decline.
- The investor then sells these borrowed shares to a buyer who would pay the market price. The trader is actually betting the price would continue to fall, and they could buy the shares at a much lower price.
- To close a short position, a trader re-buys the shares and hopes at a price lower than they had borrowed. After this, they return them to the lender or the broker.
- Traders also need to have an account for any interest that the broker charges them on the trades.
Short Selling Rewards
The main rewards of short selling are listed below:
It is a Hedge Risk: Short selling could be utilized to hedge risk in a portfolio. Hedging strategies could involve buying and selling varied stocks, buying derivatives like the options of future contracts, or utilizing a combo of both. By selling a stock short, an investor could limit his/her losses if the stock falls in price.
It Creates Arbitrage Opportunities: Short selling could create arbitrage chances by enabling investors to take advantage of price differences in different markets.
Increases Leverage: Short selling could also increase leverage in a portfolio. This is because it needs much less capital than buying a stock. It can assist an investor to magnify their returns if the stock falls in price.
The Benefit from Overvalued Stocks: Short selling could also be utilized to take advantage of overvalued stocks. By shorting a stock, investors could essentially bet that the stock price would decline and benefit from the bear market.
Long-Term Perspectives: Short selling could be utilized to generate profits much faster than traditional long positions. Since profits could be made faster, short selling could be used to generate higher returns in a short time.
Offers Liquidity: By selling a security, the trader can quickly convert it into cash, which could be utilized to invest in other securities or to pay off debt. This liquidity could be especially beneficial during times of market volatility when the price is rapidly changing, and cash is needed to take advantage of benefits opportunities.
What are the Risks of Short Selling?
The risks associated with short selling are listed below:
- Possibility of Limitless Losses: When you purchase a share of stock, your downside will be limited to 100 of the money you have invested. When you short a stock, the price can keep rising. Theoretically, it means there is no upper limit to the amount you would have to pay to replace the borrowed shares.
- Dividends: Short sellers are not entitled to dividend payments from the shares that they have borrowed. The value of any dividends paid would be deducted from the short-seller’s account on the pay date and delivered to the stock’s owner. Some short sellers will choose to close the short positions before the stock’s ex-dividend date to avoid paying.
- Change in Fees: The cost to borrow a stock changes often in response to supply and demand conditions. As a result of this, you would find it no longer makes sense to keep the position open. Even worse would be a case where both the value of the stock you have shorted and the interest rate are increasing at the same time, sending your cost to carry skyward.
To Sum Up
You will have to know what short selling is at a primary level in order to understand how it works and whether it is a suitable strategy for you to start trading with. However, this post details the risks and rewards associated with this strategy. Analyze both of them closely before you can start implementing them in your trading journey.
