Understanding the Process of Short Selling Shares and Borrowing Shares
Sometimes investors believe that a stock is more likely to decrease in value rather than increase. In such cases, they can make profits when the value of a stock decreases by using a strategy called short selling. Also known as shorting a stock, this strategy allows you to make a profit if the share price of the chosen stock falls -- but can also result in a loss if the stock price increases.
Why short a stock?
Why should you consider shorting a stock?
You might decide to short a stock if you think it's overvalued or predict that it will decline. When shorting, you borrow shares that you don't own and sell them, then buy them back later at a lower price to return to the lender.
There are also other reasons to consider shorting a stock. For instance, if you own a stock from a certain industry and want to protect yourself against industry-wide risks, shorting a rival stock can help. Shorting a stock can also be beneficial from a tax perspective, especially if you expect a short-term drop in the stock's price to reverse itself.
How to short a stock: 5 steps
How to execute a short-selling strategy
To use a short-selling strategy, you must follow these five steps:
- Select the stock you want to sell short.
- Ensure you have a margin account with your broker and the necessary permissions to open a short position in a stock.
- Enter the short order for the specified number of shares. Your broker will lend you the shares and sell them on your behalf in the open market.
- At some point, you'll need to close the short position by buying back the stock you initially sold and returning the borrowed shares to the lender via your brokerage company.
- If the price goes down, you pay less to replace the shares, keeping the difference as your profit. If the price goes up, you'll have to find additional funds to buy back the shares, resulting in a loss on your short position.
A short-selling example
Practical application of short selling
Here's a practical example of short selling: Say you identify a stock that's currently trading at $100 per share. You think the stock is overvalued and that its price is likely to fall in the near future. You decide to sell 100 shares of the stock short. Follow the steps described above, and initiate a short position.
When you sell the stock short, you'll receive $10,000 in cash proceeds, less your broker's commission. The money will be credited to your account as with any other stock sale, but you'll have a debt obligation to repay the borrowed shares sometime in the future.
Now, let's say the stock falls to $70 per share. You can close the short position by buying 100 shares at $70 each, costing you $7,000. You collected $10,000 when you initiated the position, so you're left with $3,000 – your profit, minus any transaction costs your broker charged during the sale and purchase of the shares.
What are the risks?
The potential drawbacks of shorting a stock
Keep in mind that the example above assumes the stock falls as expected. The biggest risk of short selling is that if the stock price rises dramatically, you may struggle to cover the losses. Theoretically, shorting can result in unlimited losses as there's no upper limit to how high a stock's price can climb. Your broker won't demand an unlimited supply of funds to offset potential losses, but if you lose too much, your broker can issue a margin call, demanding you close your short position by buying back the shares at what could be the worst possible time.
Additionally, short sellers might have to deal with a situation that forces them to close their positions unexpectedly. If a stock is a popular target for short sellers, it might be difficult to find shares to borrow. If the stockholder lending you the shares wants them returned, you'll have to cover the short. Your broker will force you to buy back the shares before you're ready, potentially at an unfavorable price.
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Be careful with short selling
Short selling has the potential to yield profits when a stock decreases in value, but it carries significant risks. Short selling should be approached by experienced investors, and they should proceed with caution after a thorough assessment of the risks involved.
College of Business Instructor at FAU's Business Department Website: Short selling might be risky, yet profitable. What are the significant advantages and disadvantages to contemplate before shorting a stock?
Johan: The risk/reward balance isn't entirely unrecognized by investors, but there seems to be a lack of comprehension regarding the risks in short selling. The advantage is straightforward. As an investor, you're not just capable of earning a profit by purchasing shares when prices rise, but also when prices fall. It isn't a novel approach for experienced investors, but unfortunately, recent occurrences appear to have illuminated the allure of short selling to individual investors. I came across some information lately indicating that up to 25% of trading volume in U.S. equity markets pertains to short positions. The advantages of shorting the market, if executed correctly, aren't solely restricted to investors. Yes, as an investor, you're effectively "making money off misfortune," but you're also contributing liquidity to the market. Short positions facilitate simpler pricing for market participants, thereby theoretically preventing other investors from overpaying. The risk is that many investors may not fully grasp how the market operates, for instance, understanding how market manipulation can intensify risk.
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You might consider shorting a stock if you believe it's overvalued or anticipate a decline in its value. Short sellers can borrow shares they don't own and sell them, intending to buy them back later at a lower price. This strategy can be beneficial from a tax perspective, especially if you expect a short-term drop in the stock's price to reverse itself.
When executing a short-selling strategy, investors must follow five steps: select the stock, ensure a margin account and necessary permissions, enter the short order, buy back the stock to close the position, and pay less if the price goes down, keeping the difference as profit.
