Abstract：Most investors make money by buying securities in anticipation that their prices will rise over time, and then selling them at a profit later. This is known as ‘going long’. Contrarily, short selling is a way to make money in a bearish market by betting that a security will decline in value. Beneath the surface of seemingly altruistic efforts, short sellers possess a profit motive, aimed at profiting from impending drops in securities prices.
What is Short Selling？
Short selling refers to the practice of borrowing securities from a broker and promptly selling them with the anticipation that their price will decrease shortly. Once the price falls, the trader repurchases the security at the lower price, returns it to the broker, and keeps the profit that results from the price difference, excluding any loan interest. The theoretical risk associated with short selling is infinite, which is why it is only recommended for experienced investors.
To illustrate, imagine you borrow ten shares of a company and sell them immediately on the stock market for $10 per share, earning $100 in total. If the share price falls to $5, you could use the $100 to repurchase all ten shares at the lower price of $50, return them to the broker, and earn a profit of $50 on the short position, after accounting for commissions, fees, and interest.
Short selling was once viewed negatively because profiting from a companys misfortune and a declining stock price was seen as cynical, leading to critics labeling those who engaged in it as “bottom feeders.” However, despite this perception, short sellers have always played a vital role in markets by exposing weak companies, fraudulent behavior, and falsified financial data. Their actions promote market efficiency and honesty to some extent.
Why ‘Short Selling’ a Financial Asset？
To Speculate: Traders employ the short selling strategy as a means of speculation, which involves assuming a high level of risk in exchange for the possibility of high returns. While long-term holders tend to analyze a companys financials, management, and growth potential to make decisions, speculators typically focus on analyzing short-term price movements and market signals to seek quick profits.
To Hedge: Shorting a security can also function as an hedging approach. For example, if an investor has doubts about a company‘s near-term performance but wishes to maintain a long position in its shares, they can sell them short to offset potential losses. This approach involves retaining their shares for the long term while buying back in at a lower price if the stock’s value drops. The objective is to mitigate the losses of their long position.
What Is a Short Squeeze？
When an assets price experiences a sudden surge, investors who had taken short positions on the asset will hurry to purchase shares in order to cover their positions. This leads to an increase in demand for the asset, attracting new investors to buy in as well, which pushes the asset price up even further. This phenomenon is referred to as a short squeeze, and it can cause short sellers to suffer losses that are significantly greater than their initial investment.
The short squeeze experienced by GameStop's shares in 2021 serves as an example, as short sellers expected the stock price to fall but it did not, resulting in estimated shorting losses of up to $5 billion according to analysts.
How Short Selling Differs from Traditional Trading？
Short selling differs from traditional trading in several ways:
Direction: When trading, assets are usually bought with an expectation that their prices will rise, while when short selling, assets are sold with the expectation that their prices will fall.
Timing: As a traditional trader, you need to time your purchases to coincide with market movements that will lead to a price increase. Short selling, on the other hand, involves timing sales to occur during market declines that will lower prices.
Suppose you're considering trading stock XYZ, which recently experienced a drop from $90 to $66 per share, followed by a rebound to $84. If you believe the stock is likely to decline again, you may develop a trade plan after researching the company's fundamentals and analyzing recent price movements. Your plan might involve: *You should only enter a short position if the stock price is below $80. *You should place a buy-stop order at $84 per share in order to limit your potential loss to $4. *If you are holding a position at or below $74 per share, close it out at that price.
What are the Short Selling Metrics？
Two short-selling metrics are primarily used by traders to determine whether a security is overvalued or likely to decline in value in the near future. They are as follows:
Days to cover ratio – Also called the short interest-to-volume ratio, it measures the correlation between the number of securities with short interest and the volume of their trading. It gives an indication of how well a security is performing based on its demand. Consequently, a high ratio indicates a bearish trend for a security.
Short interest ratio – This statistic indicates the ratio between the number of shorted securities and those that are afloat in the market. If the ratio is high, it indicates a high level of short interest and a substantial probability that the price of the security will fall in the future. Conversely, high short interest ratios also increase the likelihood of a short squeeze.
How to Short Sell Stocks？
Short selling stocks involves borrowing shares of a stock from a broker and selling them in the market in hopes of a price decline. Heres how to short sell stocks:
For example, if you borrow and sell 10 shares at $10 each, generating $100, but the shares rally to $50 or $100 each, you may have to buy them back at a loss of $400 or $900, respectively. This risk can continue indefinitely, and the longer you wait for the stock price to fall, the more you'll pay in interest on the borrowed shares. If the losses become too great, a margin call may be issued, and the short-seller may be required to put up more collateral in the account or close the position by buying back the stock.
Due to the markets tendency to rise over time, short selling can be challenging to achieve consistent profitability, and the risk is generally higher than with a buy-and-hold strategy, especially for inexperienced investors.
Guidelines for Short Selling:
A wrong guess about price movement can cost a seller money when short selling. Here are some guidelines to follow when short selling:
Identify your Asset: To successfully short sell, it is critical to select assets that are overvalued, have questionable fundamentals, or are declining in value.
Know your Margin: To hold a short position, an investor must maintain sufficient equity in their account to act as collateral for the investment margin, which is typically at least 25% per exchange regulations. However, brokerage firms may set higher minimums depending on the risk associated with the security and the investors total holdings. Short positions can be held for any duration but remember that interest is charged on borrowed shares throughout and margin requirements must be met.
