Interested in how to short a stock in trading or simply wanting to know the basics of shorting in trading a stock or market? Tired of investments and less risky trades that have a low profit? Are you a risk-taker? Do you have an aggressive trading personality?
Then this article is for you.
Short trading or selling is when a trader borrows the shares of a company through the broker and sells them at the current market price. When the stocks lose their value, the short seller repurchases the stocks and pockets the difference – traders can sell other instruments short, such as options.
We hope for the worst
We always think that the only benefit we get from trading is if the company we’re investing in grows its stock price. We are used to the idea that we buy stocks at a lower price in the hope to sell them later for a higher price, right?
With selling stocks short, it is the opposite.
When we borrow the stock, we expect its price to decline or that the company faces bankruptcy – we hope for the worst for them, so we can have the best for us.
This way, we’ll buy the stock back at a lower price and replace the shares we borrowed in the beginning while pocketing the difference.
This image taken from The Balance exemplifies the transactions:
An unbreakable promise
There are a few conditions for the short sale transaction.
Short-sellers have to promise to buy these shares later after they sell them, and cover the dividend income out of their own pocket. This promise is unbreakable.
Dividend replacement payments are required along the whole process of selling shorts since the trader needs to cover the dividend income no longer available on the original shares.
Reasons for short selling
Traders who are successful in short selling make a profit with the difference between the sell and buy prices. Some traders do this type of trading with speculative purposes – they believe that the company will have a drop in the stock prices and want to benefit from that.
There are also traders who sell shorts as an insurance tool – they usually have a long position owning shares of the same company, and want to reduce their risks by weighing their money. This is called hedge, and it is a way to reduce the risk of a long term portfolio.
In the second case, short selling is a way to balance other types of trades, such as swing trading. The trader is investing money on the growth of the share’s prices but also on the fall.
What happens when I short?
A few different things can happen when you short stocks. I’ll give an example of a short-selling transaction.
Imagine that you are continually checking a company’s stock price, and one day you saw that it was overvalued for some reason – let’s call this company XYZ. If you think strongly that the stock price is going to fall soon, you can choose to borrow some shares of this company at the overvalued cost.
Let’s say the shares of XYZ were commonly varying between £20 and £30, and one day it jumped to £70. You decide to borrow 10 shares of XYZ’s stock from your broker.
You borrow the XYZ’s shares and sell them later, pocketing £700 total. Now you need to pay a small commission and might need to pay dividends (I won’t add them here to make it simpler).
You’re committed to buy those shares shortly to return the 10 shares you’ve borrowed. When you borrowed the shares, you speculated that the share’s price would go back to regular – let’s picture 2 situations:
- XYZ shares’ prices go down to £30
In this case, you’re lucky! You did pocket £700, remember? Now you need to repurchase the 10 shares for £30 each – £300 total. You now have £400 of profit. That’s amazing.
- XYZ shares’ prices go up to £100
That is pretty bad for you, girl. You only pocketed £700, but now you have to buy 10 shares of £100 each. In this case, you’ll have a loss of money – you’ll need to pay £1,000 for the shares, taking £300 out of your own piggy bank.
Disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
The risks of short selling
Short selling is a profitable trading instrument, but you’re exposing your capital to a significant financial risk.
All speculators should know that traders and investors attempt to drive up the stock price if they see that a specific stock has been shorted by many people.
You won’t be able to always buy the stock back whenever you want at the wanted price – someone must be selling the stock for you to buy. Prices can go higher than you imagined, and this can significantly affect your capital.
Short selling is best used by seasoned traders, who understand risks and know what they can lose. The profits are limitless but so are the losses.
Conclusion on how to short a stock
I don’t recommend short selling for beginner traders, because the prices can go as high as possible. I don’t want you to face debt or ever to stop trading.
Focus on trading with regular and less risky instruments first, before diving in the world of short selling.
Have you ever shorted in trades? If so, what is your experience with that?
Let us know in the comment box below!