Introduction to Short Selling Stocks

A steep decline in the stock market is bad news for most investors. The more exposure you have to the markets, the more you suffer in a downturn in share prices. But not all investors fear a market downturn. There are some who actually take advantage of it. These are known as short sellers.

Table of Contents
Chapter 1: Introduction to Short Selling Stocks
Chapter 2: Short Selling Terminology
Chapter 3: Short Selling Limitations and Risks
Chapter 4: Who Should Get Involved in Short Selling
Chapter 5: Factors to Consider before Short Selling

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Chapter 1: The Long and Short of Investing
- How Short Selling Works
- Example
- Other Forms of Shorting

Chapter 1: The Long and Short of Investing

A straightforward investment in stocks by buying shares to sell at a profit is said to give the investor a ‘long’ position. Such an investor gambles on the share price rising in the near future. On the other hand, when you borrow stocks and sell them in the market, hoping to buy them later at a lower price, you are said to have a ‘short’ position on the stock. ‘Going long’ is the exact investing opposite of ‘shorting’.

A short seller hopes that the price of a stock will spiral down in the near future. To facilitate this kind of trading, he borrows shares from his broker to sell them. When prices fall, he returns the shares by buying them at a lower price, thus making a profit on the difference between the purchase price and the sale price. A short seller thus uses declines in the market to his advantage. He makes money when the stock prices fall and loses when prices go up.

How Short Selling Works

The broker arranges for the stocks requested by the short seller from the market, fund management companies, custody banks, other brokerages or margin accounts of other customers. It is however uncommon for the broker to actually purchase the shares from the market because this increases his exposure. The assets are sold in the market at prevailing prices and the investor thus opens up a short position.

The short seller then tracks the market to gauge when he can buy back the securities at a low price. After buying back the stocks, he returns them to the broker, which completes the second leg of a short sale transaction. The difference between the sale proceeds and the purchase price he will have to pay to buy back the shares can make a substantial profit, but it may also lead to losses.

It is important to remember that the ownership of the securities still lies with the broker as he has simply loaned them to the short seller. The proceeds from them, bonus shares, dividend etc should all have gone to the broker. As the short seller has received the proceeds of the sale, he has to compensate the broker for all these earnings on the borrowed securities.

Example

Peter is a short seller. He has borrowed 100 shares of Kiddy Toys from his broker and sold them at a price of $25 a share. The sale proceeds deposited into his account now amount to $2,500. Peter has heard that Kiddy Toys is losing market share to its closest rival and the company could report a loss this year. He is hoping that when the results are announced, Kiddy Toys will take a beating in the stock market, sending prices into a nosedive.

A week later, the company does announce a big loss. Investors react to the news and the company’s stock price goes down to $10. Peter now buys 100 shares at this price, costing him $1,000 and returns the loaned shares to his broker. The difference between the price at which he bought the shares ($2,500) and that at which he sold them ($1,000) is his profit ($1,500).

What’s more, Peter has made these gains without any significant capital investment of his own. Of course, he will have to pay commission and fees to the broker and also have to maintain a margin amount in his account, but his returns from the trade will still be quite impressive.

Other Forms of Shorting

Short selling can also be carried out with shares borrowed from a source other than your broker. Almost the same rules apply and the shares have to be repaid to the lender to ‘square off’ the transaction.

Sometimes, short selling may be done without actually taking possession of the shares. This is called ‘naked short selling’. Day traders often carry out transactions in this way. The expectation of a fall in share prices is lodged with the broker, who simply records the initial price rather than actually sell shares or deposit credit into the day trader’s account.

At the end of day, the broker pays the day trader the difference between the initial price and the closing price of the stock if the prices have declined. The day trader pays the broker the difference between the two prices if the prices have risen. The day trader makes his gains by betting on the movement of shares on a daily basis and most of the transactions are conducted without his taking possession of the securities.

An investor is also said to have shorted when he gains in some other manner from a fall in the price of a stock. He may not have actually planned the gain but the profits may have accrued inadvertently. For example, you can gain from having a put option on shares whose value has declined from the strike price, allowing you to sell at a higher price than is available in the market.

Next Chapter: Short Selling Terminology