The Complete Guide To Short Selling
Short selling seems like the next logical progression after learning the basics of stock investing.
However, don’t be fooled: while short selling has the potential to reap greater profits than long-term investing, it also carries with it an exponentially greater risk of loss.
As such, it’s important to understand the nuances and strategies involved in successful short selling before diving in head-first.
This article will give you a rundown of the basics of short selling, how to do it, and the advantages and disadvantages of this mode of investing.
The sheer scope of this topic means we can’t cover the entirety of it, but we’ll give you a framework to help you understand the concept a little bit more.
What is Short Selling?
Short selling is an alternative form of investing in which investors make money by predicting that a particular stock will decline. This trading strategy is conducted through a brokerage margins trading account (or directly through a broker themselves), a platform that allows these investors to borrow stocks with a fee and then sell them to the greater market for a profit.
To get a better understanding of this concept, it helps to examine it from the perspective of traditional investing. Most people purchase stocks they think will increase in value. They hold it for some time and, theoretically, sell it once the price is favourable and they can get a profit.
In short selling, the strategy is fundamentally different. Instead of buying stocks that they believe would gain in value, investors borrow the stock that they believe would decrease in value. If their prediction is correct and the price of said stock drops, they get to sell it for a profit.
How To Short a Stock?
Shorting a stock has become more accessible over the years, with many day traders and intermediate investors turning to online platforms to fulfil all their trading needs.
Before diving into shorting, it’s important to be aware of the risks involved in this advanced trading strategy. The maximum loss you can incur from investing in a traditional stock is the amount you put in.
In short selling, however, you can lose exponentially more, as there is no limit to how high a stock can go, and consequently, how much you’ll need to repay for borrowed stocks.
Disclaimer aside, here are the steps to take when shorting a stock:
- Secure a margins account. You can’t buy securities or borrow money without a dedicated margin account. Not all brokerage firms can facilitate this process, so be sure to find one that can. Furthermore, some brokerage firms and local regulatory bodies may put forth minimum requirements as part of the application process, so be sure to know what’s needed and have them sorted out before applying.
- Research short-sale candidates. Once your margins trading account is approved, select the stocks you wish to short. The stock selection process can be an entire strategy on its own, with many traders considering factors like a stock or the market’s technical trends. Furthermore, not all brokerage firms offer a wide range of shorting options. Most firms do allow shorting on the ASX, though. Short Selling on the ASX with HALO Technologies and other brokerage firms is recommended for first-timers since markets are historically less volatile than individual stocks.
- Know your game plan. Have an exit strategy before you even open a position. This way, you won’t succumb to emotion-based trading decisions. Know when to exit when you’re in the green, and prepare a contingency strategy for when you find yourself in a losing position.
- Open a position. After you’ve conducted sufficient research, you’ll then need to place an order for your short stock. This is done through the trading platform which comes with your margins account. You’ll be asked to specify the number of stocks you wish to borrow, as well as how you’d like to pay for them. You’ll also incur an interest rate and borrowing fees for as long as the position remains open.
- Buy back the stock. If the stock’s market price indeed has gone through a decline, you can buy the stock for less and therefore make a profit (excluding the borrowing fees and interest rate). This means your stock-shorting stint was a success. Conversely, if the stock’s market price jumped, you’ll need to stomach the loss instead and either reevaluate your stock shorting strategy or find another means of investing.
The steps above cover the basics of short selling.
As with any other form of trading, the market is constantly changing and you’ll need to be able to adapt your strategy accordingly. To mitigate large swings in price volatility, having a stop-loss in place is recommended to prevent you from losing more than you can afford.
Risks of Short Selling
Short selling carries a number of risks that investors should be aware of. Even if a stop-loss is in place to prevent unlimited losses, there are other factors that can be detrimental to your overall investment portfolio. These include the following:
- Variable interest rates: If there’s a surge in demand for shorted stocks, the lending rates can rise significantly. In times of extreme volatility, this interest rate can be very pronounced. It could be 20% one night, and 80% the next day.
- Dividend payments: Short sellers will stomach the cost of any dividends that are paid to the original owner of the borrowed stock. That’s why many short sellers refrain from shorting stocks that have a dividend due soon to avoid payment.
Margin calls: Your brokerage may require you to deposit more money to meet the minimum equity requirements in case stock prices rise. Failure to do this could mean an immediate closure of your position.