Short Selling: Basic Knowledge and Advantages

Short Selling – Basic Knowledge and Advantages: In this article, we will talk about a reverse trading technique – short selling. It works utterly opposite to the traditional stock market trading, i.e. buy cheap, sell expensive.

We will start our post with explaining short selling and the psychology of short-sellers and then move to the working of this strategy, will discuss some ideal conditions, where you can use it. And, finally, an example, followed by a conclusive post!

Short Selling: Explanation

Short sell is a popular trading technique to make money from falling stocks. It is a strategy used by many traders when they expect any stock to drop. Unlike the conventional trading method, which is to buy the low-cost shares and sell them when the prices move upwards, and thus make profits.

Although it is a high-risk technique to make money and the loss is also not limited here. But, on situations like market crash and correction, or if a user thinks any financial instrument is overvalued, it can help traders earn. This strategy is usually not used by big fat investors; instead, it is used by speculators, individuals, hedge fund managers, and gamblers of the stock market.

In simpler words, short-sellers are those traders who bet on prices going down shortly. And, if the stock falls, they profit, and if not, they lose.

How? Let’s know!

How Short Selling Works?

The working of short working is quite complicated and difficult to understand. That’s why please read every line, word carefully. Once you know it, then it’s an easy game!

Short selling lets a trader sell the stocks which he does not own. The trader borrows the desired share at the current market price from his broker, remember BROKER! And sells it to the market, at the current price;

Now, if the stock price falls, he has already sold the stock at a higher price, and now he’ll buy the shares from the market at the existing lower cost and will return it to the borrower.

Note to remember is- the borrower doesn’t care about the price of the share; he needs the exact number of shares, which you borrowed.

For this lending service, the broker charges a small commission, which is quite fair.

It is Like Inverse Trading

In simple words, short selling is when a trader thinks a share price will go down. So, he sells the borrowed share from a broker at a higher price in the market today and eventually waits for tomorrow to buy the same shares at a cheap cost. And, return it to the broker.

Fun Fact: The real stock lenders are not brokers but the individual investors, like us, who believe that the share would not rise. The broker is just a medium!

Example

A trader believes that Unilever Limited is overvalued today at $1000, and will fall in the upcoming week. So, the trader borrows some 100 shares of Unilever and’ shorts’ them in the market, i.e. sell, at $1000. For this, he pays interest to the broker. Thus, without owning any asset, he can profit from the falling market.

Now, next week, Unilever Limited falls to $900, and he thinks not to greed and repurchases them. So, he purchases the shares from the market at $900 and returns them to the broker. Therefore, making $100 on each share, and 100 * 1000 = $100,000 profit in a week.

Sounds amazing!

However, if the share price of Unilever Limited would have touched $1100, then the trader would lose $100,000 in a week! He sold the shares at $1000/per share, and now the value is above it. But, the trader borrowed the stocks and needs to return it, along with interest.

Furthermore, one should not make any financial decision until and unless he knows the cost of the decision. And, that’s why below are some points on the costs associated with shorting a stock.

Margin Cost

Short selling works on the leverage system, and that’s why you need to pay some margin amount only. However, the leverage facility providers usually charge margin interest for their leverage. The more you’ll keep the stocks; the more interest charge!

Borrowing Cost

Most stockbrokers charge borrowing costs in the name of “hard to borrow stocks“. The hard to borrow stocks are generally high in demand or short in supply. However, the only shares with no borrowing cost would be the losing ones, i.e. whose prices will go up.

Dividend

If a trader borrows any dividend stock, then till the time he keeps the asset, he has to pay the dividend to the lender.

So, it was all about short selling and short sellers. Before wrapping up now, have a look at the below figure. It will clear your mind on the topic.

Conclusion

Most of the people criticize the shorting technique because of the high cost and high risk associated. However, many great investors earn from it too.

If you ask us, then we would say if you are a newbie in the trading game, then you should avoid it. But, if you have been in the stock game for some time now and actively believe in your guts, then no one can stop you.

Just don’t lose the calm by trading aggressively.

At last, before short selling carefully examine the company through fundamental and technical tools. And, do not spend in a volatile share.

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