What is Short Selling?

How to Short a Stock?

At its most basic form, shorting a stock occurs when an investor or speculator borrows shares of a company from an existing owner (usually a stock broker) and sells them at the prevailing market price. This is done, on condition, that the shares would be replaced at some point in the future. Short selling stocks is done with the hope that prices will decline in the future. As a result, short selling is only done on a margin basis, where investors put up part of the total capital outlay and borrow the rest from the broker. This can be a double-edged sword; traders stand to pocket huge profits if the prices drift lower, but can also lose a lot, even with marginal price increases.

In a market dictated by demand and supply, short selling carries with itself a risk known as a short squeeze. A short squeeze occurs when a stock does not fall as expected. When this happens, short sellers begin to buy stock to cover their short positions.

But large traders (usually hedge funds) curb the risk of short selling by short covering. Short covering is the practice of buying stocks to ‘cover’ or hedge an open short position. Short sellers expect prices to go down, but if they go up, they can decide to lower or eliminate their exposure to the short position.

This allows traders to protect themselves against an unexpected market move.

Conventional short selling involves selling a stock borrowed from an owner; naked short selling entails shorting a stock you do not own, have not borrowed nor positively determined that they exist. This could mean that a seller may fail to deliver the shares to a future buyer and this can lead to market distortion. In the worst-case scenario, naked short selling can even lead to a market recession.

ADVANTAGES OF SHORT SELLING

Short selling has many advantages that attract many traders, new and experienced alike:

• Short selling grants traders access to instruments that they would otherwise not be able to trade. If one wants to benefit from a decrease in an instrument’s value, he can do it without owning it.
• Going short on an instrument, meaning opening a selling position on the platform, allows traders to benefit even when the markets are going down, as will be explained in the example later.
• Short selling minimises the risk the trader takes. There is no need to buy and sell instruments in “real life”, rather trade them electronically and profit from the fluctuations. Moreover – should a person own crude oil, and its price drops dramatically and suddenly, the person is left with a merchandise that is worth less from the time he bought it, and without potential buyers.
• In short selling one can monitor and control his investment with the use of different market orders, stop loss and others. These can prove critical when short selling.

Just like going long, one can employ leverage in short selling, and open positions larger than his capital.