Short selling shares

If you aren’t an experienced investor but just starting to approach the fascinating world of investing in the stock market, then probably short selling shares is not the appropriate way to start your journey as it involves a great amount of risk. This being said, to become a skilled investor, the more you read the better so let’s take a closer look at what short selling is all about.

What is short selling of shares

Short selling is the selling of stock shares that you don’t actually own. This is done through a margin account with your broker. Since you did not own the shares, sooner or later you will have to give back the shares. The process of closing your short position is known as covering. When you short sell, you want the share price to drop because you end up buying back the shares at a lower price to close your short position, thus make a profit on the difference. Since you did not own the shares to start with, if the share price appreciates then you are in trouble because to close your position you will have to pay a higher price than you initially sold the shares for, thus taking a loss. This is why it is so risky and should be avoided by non-experienced investors. The more the share price rises, the wider the potential loss.

Short position versus Long position

In general investors believe that investing in the stock market is all about buying shares of a company and selling them at a higher price in the future for a profit (capital gain). This is known as taking a long position. What several ignore is that it is possible to make a profit on just the opposite. Investors who take a short position make a profit only when the share price depreciates. Investing in stocks (equity investing) is already considered as a high risk investment, but if you opt for shorting, the amount of risk is even greater since you are selling shares that you do not actually own so be aware.

Why short selling shares

The two main reasons for short selling are speculation and hedging. In the first case, investors are trying to make a big profit in a short amount of time. For example, this technique is widely adopted by experienced day traders. It is also common during a bear market. Short selling can also be use to hedge risk of a long position in the same stock.

Share short sell example

Stock A1 is trading at $10 and experienced investor Bill who believes the share price will decline decides to short sell 200 shares of stock A1. The trade takes place by “borrowing” the shares (from the brokerage firm) and selling them. Bill is now short of 200 shares as he sold shares that he never actually owned. Recall that sooner or later the short position must be closed, as the shares are borrowed. A month after the short sell, following the quarterly earnings announcement of company A1 which missed the market’s expectations, the share price drops down to $8.
Bill buys 200 shares of company A1 and closes the short position. This leaves Bill will a profit of $400 (excluding any commissions and interest on the margin account).

Margin account

Since short selling involves selling shares of a stock that you actually do not own (you are borrowing shares from the broker), you cannot use your regular cash account but must open a margin account. Through the margin account the broker will lend you money and will use the investment as collateral. The broker charges interest on margin accounts so the longer you hold your short position open, the greater amount of interest you will be paying. It is also worth noting that although you can keep your short position open as long as you wish, brokers can force you close your position if they want the shares back. This however does not occur often. If the stock in which you have a short position pays any dividends out to the shareholders, you are not entitled to them as you borrowed the shares (you have to pay them to the lender of the shares).

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