What is short selling and how does it work?
Many traders benefit from buying stocks at a low price and then selling them when they appreciate, at a higher price. That is indeed the most traditional way of trading stocks. However, what happens when the market is not bullish? Market fluctuations are unpredictable, and during times of recession or poor economic health, declining markets may put a damper on the financial markets. When this happens, intermediate and advanced traders take to short selling – the ‘opposite’ of ‘regular trading’. If you are eager to benefit from declining markets or to curb your losses, you may consider this strategy.
In this post, we will explain what short selling is. We will lay out a few benefits and why people participate in it, but we will also go through some limitations and risks when it comes to short selling. The goal is to provide a comprehensive view of this trading strategy so you can make a sound decision. We will also give a few tips to traders on how they can protect themselves and their assets when they try out short selling.
What is short selling?
Short selling is a trading strategy that is based on traders going short or selling securities. In the stock market, this would be when traders borrow stocks so they can sell them. Traders short-sell a stock for the main reason: to benefit from declining markets. Just as regular traders buy a stock when its value is appreciating, hoping they can sell the stock later at a higher price, short sellers use the same theory. They borrow stocks to sell them at a higher price, so they can buy them back later at a lower price.
Traders may short-sell to speculate on an asset price or to hedge an existing position. The latter is especially prevalent, as declining markets may mean losses for traders who regularly buy stocks that are now depreciating.
When to short sell
Generally, most traders expect stock values to rise over time, as this is the general development of the stock market. Therefore, short selling is not a popular strategy to be used all the time. When markets suddenly become bearish or the financial markets experience disruption, that is the best time to short-sell. Many traders will jump at this short-term opportunity, and they will exit their trades just as quickly as they have entered them.
What is a short squeeze?
If you have heard of short selling, you may also have heard of the term ‘short squeeze’. A short squeeze occurs when there is a sudden, sharp increase in the share price of a stock. This usually happens when there are many traders taking a short position for a certain stock and some begin closing their position and buying back the stock, causing its share price to increase. Other traders then get the signal to buy back the stock as well, pushing the price higher and higher over a short period.
Benefits of short selling
There are several benefits of short selling.
New opportunities
The biggest benefit of short selling – and the main reason why traders participate in it – is to benefit from declining markets when they occur in the short term. Short selling allows traders to find opportunities even in bearish markets, especially when they predict that the stock market will take a big tumble. This allows them to profit from market conditions, as well as to limit their losses from existing positions.
Low starting capital
Another benefit of short selling is that traders do not need to have a high starting capital. They can borrow shares from a provider, which is usually their bank or broker. If they make a successful trade, they have essentially benefited from having owned no assets.
Risks of short selling
Nevertheless, short selling is a risky activity and most traders do not attempt to do it. This is due to a couple of reasons.
Possibility of unlimited losses
Short selling is a risky endeavor because traders run the risk of unlimited losses if they are not careful. For traders who participate in ‘regular’ trading, the lowest a stock can decrease in value is $0. This means that however much money they invested to buy the stock in the first place, that is the maximum amount they lose should the company go bankrupt or the stock tank miserably. However, that is not the case when short selling.
Short sellers predict that the market will be bearish. But if the stock price ends up skyrocketing, there is no limit to how high the value of a stock can go. This poses a huge risk to short sellers. Say, a trader borrowed 1,000 shares to sell at $50 thinking that it will depreciate to $45, in which they will buy back later. The stock market takes an unexpected turn, and the stocks rise to $100 a share. In this case, the trader must purchase the shares at $100 to pay back the lender.
Associated costs
There are also costs and fees associated with shorting stocks. They include margin interest, stock borrowing costs, dividends, and other payments set by your broker. However, traders can mitigate them by choosing a broker that has low borrowing costs and does not charge extra fees.
Short squeeze risk
Finally, there is the risk of a short squeeze occurring while you are holding a short position. This can have devastating effects on you as a speculator if you fail to move quick enough and buy back the stocks you borrowed to sell. One example is that of the GameStop stock. It experienced a short squeeze in early 2021 when its stock price rose more than 1,600% in two weeks.
How you can protect yourself from risks
Due to the risky nature of short selling, traders would do well to have a few tools on their belt when it comes to protecting themselves and their capital.
Be aware of your risk appetite
The first is to be aware of your risk appetite. Know how much money you have and know how much money you can realistically afford to lose. Never overtrade or trade with more money than you are comfortable with because there are no guarantees in trading. If you are sensible and aware of your risk levels, you can trade with a much more level head.
Respond to market movements quickly
Another crucial element to protecting your capital is to respond to market movements quickly. You can manually monitor markets. You can also set parameters that can be executed when a certain market breaches certain boundaries. This allows you to stay on top of the market and never miss an opportunity to exit the market, which is just as important as having a strategy to enter the market.
Abstain from short selling
Finally, short selling is a hugely risky strategy, and traders should ensure they are experienced enough in the markets to participate in it. If that is not you, or you have a lower risk appetite, there are alternatives to short selling you can choose. One example is to opt for financial derivatives such as options contracts instead, as they will allow short stocks and benefit from bearish markets without having to borrow the stocks to own in the first place.
The bottom line
Short selling is not a journey for the faint of heart, but it is certainly an interesting one. The key to keeping your capital in check is to understand how the market works, never trade more than you can afford to lose, and decide if short selling is worth it for you at all.