- 1 Introduction
- 2 What is Shorting?
- 3 How to Short Stocks in the Spot Market
- 4 How to Short Stocks in the Futures Market
- 5 How Can You Make a Profit by Shorting Stocks?
- 6 How Can You Lose Money by Shorting Stocks?
- 7 How Can You Hedge by Short-Selling?
- 8 What is the Best Time to Short Stocks?
- 9 Can You be Penalized for Shorting Stocks?
- 10 Conclusion
Going short or shorting is a different concept from the traditional transactions that we are used to, which involve acquiring something before selling it. It is very common for you to buy a product and then sell it after a duration. However, when it comes to shorting, the trading is different, as you presell your product before acquiring it, instead of investing in a stock for years.
What is Shorting?
Suppose your friend wants to purchase a new gadget, but it is exclusively available for limited people, and you are one among them. So, your friend pays you a slightly higher fee to pre-book the limited phone from you, even though you do not have the phone yet.
The method of selling your stock before you have purchased it is known as short stock or shorting.
The goal of every transaction is to buy cheap and sell at a higher price to incur a profit, irrespective of the order of purchase and selling. The basic idea is that when you feel that the price of a stock is about to rise, you buy the stock first, and sell it later.
However, as a day trader, if you feel that the price of the stock is going to decrease later during the day, you can sell your stock before buying by shorting.
How to Short Stocks in the Spot Market
Once you short sell a stock in the spot market, you need to set up trigger limits that auto-stop and initiate buyback, once the target reaches a lower or an upper limit. You can either buyback before the stock price hits the buyback limits or wait for a trigger. However, you need to buy back before the market closes to avoid penalties.
How to Short Stocks in the Futures Market
The futures market is a derivative based on underlying assets and is both highly rewarding and highly risky. Unlike the spot market, if you feel bearish about a stock, you can hold it overnight for multiple days. However, you need to provide a margin deposit even while shorting stock in the futures market.
The futures market is based on market movement. Your earnings are a cumulative total of the daily difference between entry price and closing price until you square off the trade.
How Can You Make a Profit by Shorting Stocks?
Imagine that you borrowed about 100 shares of a company stock trading at $50, and sold it off to another investor. Now, you have 100 shares short, which you need to buy later.
Now, suppose the company has entered into a dismal period, and the stock price of the shares decreases to $40. You can now buy the stock and clear off the trade by making a profit of $10 for each of your 100 shares, thereby making an effective profit of $1000.
While short selling, the goal is to have the closing price lower than the entry price.
How Can You Lose Money by Shorting Stocks?
Suppose you shorted 100 shares at a stock price of $30, expecting the company shares to dip in value. But a larger company suddenly acquires the company, and the stock price for each share increases to $55. So, now you are forced to buy the stock at a loss of $25 per share with an effective loss of $2500 for the entire lot.
Furthermore, you may lose money since you need to clear off the stock by the end of the day, within the market close time for spot market share trading.
In the futures market as well, it may not be feasible to hold the stock for long due to interest and margin rates. Additionally, you may be forced to return the shares that you borrowed if the company undergoes huge losses, or many short sellers buy the shares, increasing the stock price.
How Can You Hedge by Short-Selling?
The focus of hedging is not to make a profit but to make sure that you are insured against losses. Most investors never choose hedge funds because of the costs involved.
You need to invest your money in putting up a hedge and backing it up with premiums on security. Additionally, you may also have to pay an opportunity cost based on your portfolio relation in accordance with the security if the market keeps rising.
Advantages of Short-Selling
Short-selling has the following advantages:
- There is a possibility of high profits with short-selling
- You do not need to buy the share immediately. Hence, only a limited amount of initial capital is required
- You can hedge against other holdings if you are a short-seller
Disadvantages of Short-Selling
- You need to possess a margin account for short selling
- You need to pay a margin interest against the shares in addition to the entire trade-off
- Short-selling is very risky since you may lose a lot of money
- The lender may force you to buy the shares
- You may have to undergo a short squeeze which can result in a huge loss
What is the Best Time to Short Stocks?
The best time to short stocks is right before the stock plummets, which will give you a huge difference between buying and selling prices on your shares.
Generally, a stock price drops after unexpectedly poor earnings, or when it has reached a stage where there are no expectations from the stock to perform better.
Can You be Penalized for Shorting Stocks?
If the stock price of the shares you purchased surges, and your margin account does not have enough money to pay the buyback amount, you may be penalized for it.
Generally, the stock market regulator deducts the money from the broker’s account in such cases and transfers the shares to the broker. You need to pay back the broker with interest rates.
The rules you need to remember before selling stocks –
- You should sell short only in bear markets
- Sell short only on confirmed downtrends
- Sell short when the public opinion of the company has a long way to go before falling
- Realize that you may lose a lot of money if the stock price rises, and earn only when the stock price falls
- Do not be greedy since any trend can change course suddenly
Short trading is not very popular, but, as a smart, professional trader, you must use both long and short trading according to the situation and benefit from it. When you are feeling that the stock price is entering a bear market, use short trading. When you feel the stock is entering a bull market, use long trading. Protect your investments with hedge funds.