– Reviewed by Daniel Dubrovsky, January 27, 2021
Shortening a stock involves selling the borrowed stock with the expectation of repurchasing the same stock at a lower future price and reaping the difference. Short selling is a common part of an active trader’s plan because it gives traders the ability to benefit from an evolving market and which is declining. This article uses examples to explain what a short sale is, why it is important and lists the key things to consider during a stock short sale.
What is a short sale and why do it?
Short sales is the process of borrowing shares through a broker, selling the shares at the current market price and then repurchasing the shares at a lower price to return the shares to the broker.
Why short stock? The answer to this question is multi -layered but in general, short stocks provide an opportunity to trade down stock prices.
For some people, short selling seems a bit unethical because you’re basically taking the stand that a company’s stock price will fall, which can result in large -scale layoffs that affect many households in the process. For others, this is an opportunity to speculate on stocks that are undervalued or benefit from the massive sale of an irresponsible company.
Nowadays, in addition to retailers, there are well -established hedge funds that focus on short selling, or ‘shorting’ various companies. Some short sellers publish research on companies that allegedly have reported misleading figures in the publication of financial statements or where there is insufficient evidence of corrupt business practices.
Before diving into the world of short sales, we recommend you check back stock market fundamentals.
What is meant by shortening stock?
At this stage it may be useful to distinguish between short -selling stocks in the underlying (non -leveraged) market and short -selling (selling or taking short positions) through brokers that offer leverage.
The traditional approach has been set out above, where the short seller borrows the stock from the broker, sells the stock and then repurchases the stock at a discount to return it to the broker.
However, the advent of leverage trading has simplified this process to the point where shortening stocks is just a matter of clicking ‘sell‘ button for the desired stock on the online platform.
Shortening the stock in this way involves:
- Regulated brokers: It is important to trade with regulated brokers that offer little or no leverage.
- Liquidity/Loans: To shorten the stock, the broker must have sufficient ‘borrowing’. Lending refers to having a group of liquidity providers willing to lend the necessary shares to a broker for its internal hedging needs. In the absence of a loan, the broker can no longer facilitate short sales and will disable the short sale function until sufficient loans return to the market. Again liquid stocks tend to lend larger than illiquid stocks.
- Set risk parameters: When the loan is sufficient, run the necessary analysis, set stops and limits and press the ‘sell’ button on the online platform.
How to short sell stocks
The following steps can be followed when shorting a stock:
- Select the desired market
- Confirm the declining market
- prescribe stop the loss and limit (risk to reward ratio)
- Enter a short trade
- The trade is completed when the stop or limit is reached
Traders can use 200 -day moving average or use trend line to assess whether the stock is in a trend environment.
The short selling process can be made more clearly by using actual figures in the form of practical examples.
Examples of short sales
Suppose a short seller wants to sell 10 shares of Apple Inc because he believes the stock price will go down in the near future. If Apple’s price is $ 200 and also margin the need is 50%, this means the trader will control $ 20 effectively00 ($ 200 x 10 shares) worth of Apple shares while only putting $1000 ($ 2000 x 0.5) as a margin.
The short seller set a target at $ 170 and stopped at $ 210 to create a risk to reward ratio of 1: 3. If the price reaches the target, the short seller can earn almost $ 300 ($ 30 x 10 shares), minus any financing fees and commissions.
Nominal trade value = $ 2000
Margin = 50% ($ 1000)
Profit after taking profit = $ 300 ($ 30 x 10 shares)
Potential losses: $ 100 ($ 10 x 10 shares)
This example also presents an ideal scenario but financial markets are often unpredictable and do not move with certainty as presented here. For this reason traders should adopt sound risk management practice from the very beginning.
What are the risks when a stock sells short?
When learning how to short sell stocks it is important to keep the following in mind:
- The potential for losses is unlimited –Non -stop short positions, in theory, have the potential for unlimited losses. There is no limit to the stock price can rise which in turn emphasizes the importance of stopping.
- Squeeze short –A short squeeze occurs when a short trader sees a price increase (contrary to what was expected) leading to a loss that ultimately forces the trader to buy (to close a trade) at a higher price and accept a loss.. Prices gain more upward momentum as more short sellers buy to close their positions.
Below is an example of a short pinch to use AS 500 (S&P 500):
- Stock cannot be borrowed – In a collapsing market, even the most liquid stocks can become unborrowable and therefore, prevent the opening of any new short positions. Traders need to keep this in mind but also should not allow this to force them to rush admission.
Short Selling Stock: Major Intakes
Shortening stocks has become easier with advances in technology and forms part of a trader’s skill set. However, unlike the forex market, stock traders are faced with the unique problem of non -borrowable stocks that prohibit any stock shortage. Traders should only consider starting short trades after the necessary runs technical and/or fundamental analysis while adhering to good risk management practices.
As a reminder, the 5 best options for shortening stocks are:
- Use a regulated broker: Consider using a highly regulated and reputable broker when selling stocks short.
- Stream: In the absence of a steady downtrend, traders should set entry orders at a favorable level if the market gets there. Stocks have the potential to trade gap down – especially if negative information enters the public domain. In a fast -moving market, traders can miss encouraging entries when away from the trading screen and orders can help.
- Liquidity/Loans: Does stock trading on a major exchange with a healthy number of stocks change hands every day, or is it known as a ‘free-float’? Greater liquidity tends to translate into more loans available to short sellers and more flexibility to shorten stocks.
- Borrowing charges: In addition to any overnight financing charges on open positions held overnight, there are often ‘borrowing charges’ imposed on short positions to allow short sellers to participate in the market. It is a good idea to inquire about such charges with your broker before making a trade.
- Risk management: Since short trades theoretically have unlimited losses with limited profits (prices can only go down to 0), traders need to use stops and limits to correct skewed risk reward returns.
Frequently Asked Questions short selling stocks
What are the highest stocks for short?
The stocks that become attractive to short sellers vary by industry and sector. Therefore, no single stock should be targeted by traders for short trades. Short sellers use a number of analytical techniques – particularly fundamental in nature – looking at the ratio of revenue and debt to equity but also looking at other aspects of the business such as corporate governance structure and senior management caliber.
All major stock indices can be viewed on us major stock indices page.
How long can you shorten the stock?
There is no limit to the length of time a trader can hold a long position. This is because the shares are owned directly and does not involve borrowing the shares of others. Stock shorting on the other hand involves borrowing shares that can be withdrawn by the broker at any time. There is no set time period that a trader will usually be able to hold short trades and this depends entirely on the market conditions at that time and when the stockholders want to liquidate the stock.