Short selling explained with examples

Short selling is, in a way, a polarizing activity, since it involves betting against a stock or other asset; But it can also be part of a well thought out business or investment strategy. This article explains what short selling is with the help of practical examples.

What is short selling?

Short selling is the process of borrowing an asset (usually stocks) and immediately selling it on the open market with the goal of buying back the asset, later, at a lower price before returning it to the lender. “short seller” receives the difference between the highest selling price and the lowest buying price, minus interest and fees.

Short selling is generally known in the stock market, but it can be applied to a full set of financial products provided by a broker.

Short selling examples

An astute investor has done extensive research on ABC Company and concluded that ABC’s current share price at $ 50 is well above its intrinsic value of around $ 20. refore, the investor decides to sell short. ABC calls his broker asking to borrow and immediately sell 20 shares of ABC at a cost of $ 1,000. analysis turned out to be correct and after a week ABC’s share price dropped to $ 20, at which point all 20 shares were repurchased and returned to the broker to complete the transaction.

Read our top 3 ways to rate a stock in our comprehensive trader’s guide to stock valuation

Example 1: (ideal scenario) Loans 20 shares of ABC at $ 50 per share

  • Sold 20 ABC shares at $ 50 per share = $ 1,000 income
  • Repurchased 20 shares of ABC at $ 20 per share = cost of $ 400
  • Interest and commissions charged by the broker = $ 50 commissions
  • Profit = $ 1000– $ 400 – $ 50 = $ 550 (55%)

Example 2: (Unfavorable scenario) Borrow 20 shares of ABC at $ 50 per share

  • Sold 20 ABC shares at $ 50 per share = $ 1,000 income
  • Repurchase of 20 shares of ABC @ $ 80 per share = cost of $ 1,600
  • Interest and commissions charged by the broker = $ 50 commissions
  • Profit = $ 1000– PS1,600 – $ 50 = $ -650 (-65%)

However, technological innovation has led to the universal adoption of online trading, allowing account holders to simply hit the ‘sell’ button every time they attempt to short. This depends on the broker’s ability to borrow a sufficient amount of the underlying asset (usually stocks), to facilitate the transaction.

Positive aspects of short selling

Short selling allows traders to benefit from price action not only when prices are going up, but also when they are going down. This dramatically increases the set of opportunities available to traders.

Take advantage of market cycles: Financial markets, like the economy in general, experience cycle ups and downs. Optimism rises when markets experience a bull run, but good times don’t last forever and there is often a pullback or turnaround, followed by a long-term downtrend. Trend traders can attempt to execute technical or fundamental trading strategies in falling markets in the same way that they would in rising markets by going short.

Manage risk through hedging: Traditional stock investing involves buying and holding a stock for several years in the hope that the stock price will appreciate, simply by having to suffer losses when the stock price falls. Investors and traders can reduce their exposure to a falling stock by short selling the same stock (partial hedging). A great example can be seen when people have a long-term portfolio of stocks and when the market crashes, they may try to go short to short-term to mitigate long-term portfolio paper losses. Read our trader’s guide on How to short sell stocks in declining markets.

Art Pag Forms of a Laridicle T. Classification S. Strategy: Fundamental analysts and traders study the balance sheets of companies and the sectors in which they operate to determine which companies are undervalued or overvalued. Traders and Investors Those who believe that an overvalued company could see its share price fall towards its intrinsic / fundamental value have the option of shorting this company.

Risks Associated With Short Selling

risks associated with short selling can be detrimental and warrant closer inspection.

Unlimited Loss Potential: Losses are capped at zero when you go long on stocks because once a stock drops to zero, it can’t go any lower. However, since there is no limit to the increase in the price of a share, the losses on short positions are infinite. refore, short traders should consider implementing risk management techniques to limit downside risk.

Short Tight Short Threat: A short contraction occurs when there is significant short-term interest in a stock, but the price of the stock increases more and more. This may be due to rumors of a takeover bid or a surprise hit in earnings, or a number of other factors causing a stock buying frenzy. To make matters worse for short sellers, higher prices rise, more short sellers receive margin calls and are forced to buy to close their positions; further increasing the share price. Online retail merchant communities, such as those found on or Reddit (WallStreetBets), have previously targeted stocks that have been very out in the open, in an effort to get a little squeeze. Read our article on meme actions to find out why.

Borrowing Limitations: In order for retail traders to buy stocks short, the broker must be able to borrow the required number of shares in advance. In rapidly falling markets, the holders of the real shares may want to sell, which means that the broker must return those shares and therefore cannot offer clients the opportunity to short the shares without taking additional risk. Typically, this would result in the company being unable to short sell until market conditions change and more loans are available on the market.

Short selling controversy

practice of short selling is no stranger to controversy and many believe that it adds little or no value beyond providing liquidity. Short selling gets a bad rap because short sellers are essentially betting against a company and if that company’s stock price falls, there are real-life consequences for all parties involved. Salaries and bonuses are revised downward, hiring freezes are imposed, and ultimately workers face the threat of downsizing.

Another reason short selling is viewed negatively is due to the rise of “predatory” hedge funds that specifically seek to sell short to overvalued or unscrupulous companies. In the past, representatives of such hedge funds have been featured in the media hurling fierce accusations against company management, often with a focus on corporate governance failures, which tends to close the loop, resulting in panic selling and a lower stock price. .

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