Last Reviewed and Updated October 15th, 2023 by Gabe Ross
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The term “shorting” in the stock market refers to the strategy of betting against stocks that you believe are overvalued, and whose share price you anticipate is set to drop.
In practice, shorting is the act of borrowing a stock from a brokerage or market participant for a set amount of time. Upon acquiring the borrowed stocks, you will then sell them at the current prices. You will then repurchase these stocks prior to returning them, with the hopes that the price will have indeed dropped and you can buy them for less than your initial selling price. The delta between these two prices will be your profits.
The shorting strategy is also called “short selling” and can be used with various asset classes including equity stocks, futures, and options. Short selling is often used for speculative trading and hedging purposes. For instance, if you have a portfolio of stocks and you want to hedge during uncertain times, you can take a short position in the index futures in order to hedge your portfolio.
Shorting involves a high level of risk. The price of the security you are shorting can go in both directions–up or down–and you could end up absorbing significant losses.
Additionally, you have to keep margin money in the brokerage account while shorting. This is to ensure that you have enough funds to cover any potential losses. You also have to pay a loan fee to borrow the stocks, as well as interest on the borrowed assets.
Example of Shorting
Let us look at the shorting strategy with the help of an example. Suppose you borrow and sell 100 shares of stock A for $80 each. You receive $8,000. Let us assume that in a favorable scenario, the price of stock A falls to $50 in a couple of days. You can now buy 100 shares of A from the open market at $50 per share, and return the shares to the lender. Before any associated fees and expenses, you have made a profit of $3,000 ($8,000 – $5,000).
On the contrary, let us assume the market does not behave as per your expectation and the price of stock A rises to $100. You will have to buy the 100 shares of stock A at a higher price ($100 per share) before returning them to the lender. In this case, you have incurred a loss of $2,000 ($8,000 – $10,000).
Risks Associated with Shorting
# Potential Losses – Continuing with the above example, in unfavorable circumstances, the price of stock A could rise. The higher the price of the stock increases, the bigger your losses.
# Possibility of Short Squeeze – A “short squeeze” occurs when there are numerous short sellers who are trying to close the position on a particular stock. In other words, many individuals believed that this stock would fall. The huge demand for buying the highly shorted stock bumps up its price, forcing you to pay more to repurchase the stock and leading to higher losses on the short trade.
# Possibility of Higher Margin Calls – While undertaking a short sale, you are required to keep a certain amount of securities in the form of cash, bonds, stocks, or mutual funds as collateral in the margin account. The amount of collateral to be held depends on the brokerage firm and the nature of the security. It could vary anywhere between 25% to 40%. In the example given above, let’s say you are required to maintain a margin of 30% i.e. $2,400 ($8,000 x 30%). As long as the price of stock A remains near $80, you are in a good place. However, in the event that the price of stock A rises, for example to $95, your margin requirement rises to $2,850 ($9,500 x 30%). In this case, you will have to keep an additional margin of $450 ($2,850 – $2,400) in your account.
# Change in Fees Depending on Liquidity – As mentioned above, you have to pay interest on the securities you borrow. This interest can vary depending on the liquidity and demand for the security. For instance, you may start with a lower interest rate for borrowing stock A but gradually realize that the interest has increased owing to high demand for the security and lower availability. You must consider the interest rate along with the possible profit/loss on the stock and decide if it still makes sense to continue with the particular short position.
# Dividend Payments – While holding a stock as a short seller, you are not entitled to any dividend payment on the stock. Instead, you are liable to pay the dividend amounts, if any, to the lender. Usually, the brokerage will cut such dividend amounts from your margin money. If you realize that the dividend payments are excessive and do not wish to pay them, you can choose to end the short position by buying the stock before its ex-dividend date.
Key Takeaways
Short selling is a strategy that one can employ to bet against investments that they believe are overrated. While seasoned investors can make large gains from short selling, the risks are large and novice investors would be wise to steer clear of short selling before mastering the art of trading and becoming fully aware of the downside risks.
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