Short selling, also known as shorting, is an old trading technique that traces its origin in the 17th century. Short selling has gone through radical phases of evolution in its legalisation, with the practice remaining legal for most stock markets today. While stock markets continue to suffer losses due to the recent coronavirus pandemic, short selling investors have reaped billions worth of profits in a couple of months. Following its appealing prospects, short selling presents investors with an investment opportunity. So, what is short selling, and how does it work? This article discusses what short selling entails and how you can short sell stocks.
What is Short Selling?
Short selling is a trading strategy where investors speculate a decline in the share price of a company’s stock. It all starts with speculations of the declining stock. Short sellers then borrow these stocks and sell them in an open market. They will buy the same number of shares back at a lower price once the market price of these stocks drop. The difference in prices is where the short selling profits come from.
Typically, stock investors anticipate a rise in share price, from which they generate returns from the higher price. Short selling, however, is profitable when the opposite happens. Short sellers aim at buying stocks at low prices, after initially selling borrowed shares at a higher rate.
How Short Selling Works
Traders open positions using borrowed stocks, particularly those that they speculate will decline in value in the foreseeable future. This requires a margin account for which an investor pays interest on the price of the borrowed shares. The investor can then sell the borrowed assets in an open market to a buyer who is willing to get them at the market price.
The proceeds of the trade are retained in the investor’s account, as the investor waits for a downward trend in the share price of the stocks. When the price of the stock market drops, the short seller can now buy back the same amount of stocks they had sold, but at a lower value. The trader will then return the stocks bought back to their lender. The difference in the value at which the short seller borrowed the stock, and the value of the bought-back stocks is what investors gain as profit.
Benefits of Short Selling Stocks
There are numerous reasons why you should consider short selling stocks as part of your trading strategies. Here are some benefits that investors enjoy when shorting stocks.
Speculation – Speculation is defined as investing in stocks or other financial assets in the hope of an increase or decrease in their value for profit generation. Speculation is one of the primary reasons why investors short stocks. Speculators anticipate factors and events that might lead to a downward trend in stock prices, such as an overvalued company, political instability, and announcements by the central bank. With the occurrence of such events, speculators are presented with a wide scope of investment opportunities.
Hedging Risks – Shorting stocks has become one of the most popular strategies of hedging risks posed by other assets of investment portfolios. For example, an investor may buy shares from a Company X to hold them for a long-term period of 10 years to earn profits from its continuous growth. However, this continued growth may be disrupted by short-term events, resulting in a drop in the stock’s share price. To hedge your position in Company X’s stocks, you can consider short selling them. As a result, the effect of the losses experienced by Company X’s shares can be minimised by the profits earned through shorting.
Tax Benefits – When shorting, investors sell stocks only when they have moved to a desirable value. This means that if a trader holds a stock for a long period, then they will gain more tax benefits as the investor would have to deal with capital gains in the long term. However, such tax advantages are only viable within a limited scope, including ETFs from the same sector and short selling a different stock from the same sector.
Profits in Crisis – Stock markets are typically affected by recessions and global market crashes. However, for shorted stocks, investors have an opportunity to profit from economic downturns, and do not suffer impacts from such events. For example, following the falling stock markets amid the global coronavirus pandemic, short sellers recorded substantial profits due to the instability.
How to Short Sell Stocks
This step by step guide explains the details of what goes into this process.
Step 1: Open a Trading Account and Enable Margin Trading
Identify a broker that offers short selling and activate a trading account on their platform. You will need to activate the margin trading feature in your account. Most of the brokers will require you to complete a registration form and complete a questionnaire to ensure you are aware of the risks associated with shorting. You must also be aware of the minimum deposit required before using their platform or your margin account.
Step 2: Decide on the Right Stocks to Short
Use the research and analysis tools provided by the trading platform to understand the events and factors that could affect the market prices. Undertaking fundamental analysis on market will keep you informed on the companies that are likely to struggle financially in the foreseeable future.
Step 3: Risk Management Strategy
Before you initiate a trade, be sure to develop a risk management strategy for your investment. Short selling can be extremely risky if you invest without a plan.
Step 4: Open a Position
To sell the stock you plan to short, you will need to open a shorting position. The size of the position should be in line with your investment strategy.
Step 5: Place an Order to Short Sell
At this point, an investor is required to enter a shorting order that specifies your plan to short a given stock. After placing a shorting order, investors should monitor the stock price movement to see if their profit or loss threshold is met.
Step 6: Close Your Position
If there is a decline in the share price of the stocks you shorted, then you can close your position by buying back the shares at a lower value and hopefully at a satisfactory profit level. Alternatively, if you close the position by buying back the stocks at a higher value, then the market performed against your speculation and you will have realised a loss.
You should therefore be careful in your speculations to avoid losses once the market moves against your open positions. A thorough research and analysis on the stocks you intend to short sell will help you foresee the performance of the stock, thus reducing the risk of the market going against you.
Websites where you can Short Sell Stocks
Brokers have trading platforms through which investors can borrow stocks for shorting. However, you should consider exercising due diligence when deciding on your broker of choice to avoid dealing with scammers. Here, you will find examples of websites where you can execute shorts.
TradeStation has been a choice for professional traders who are experienced in shorting stocks. Fortunately, today, TradeStation features a TS GO account through which beginners and trading novices can short sell stocks. The website is popular for development tools, stock screeners, and educational tools that enhance an individual’s trading experience. Another attribute that makes TradeStation a global leader in the trading industry is the wide range of assets featured, including cryptocurrencies, futures, options, stocks, ETFs, and other tradeable assets. Investors can, therefore, diversify their investment portfolio with multiple assets. TradeStation does not charge commissions on ETFs and stocks, and there no minimum deposit required to open a TradeStation account.
Interactive Brokers is one of the largest trading platform in the United States. This top-ranking broker is associated with low margin rates and payment of interest on idle stock balances. The platform also offers low rates of commission on the featured assets, including forex, bonds, futures, options, and stocks. Interactive Brokers also has a detailed mobile application that makes the trading experience better and easier. The low costs of commission and a wide range of account options are a reason why Interactive Brokers is considered to be ideal for shorting.
TD Ameritrade has a track record of being one of the best short selling platforms across the globe. The broker features downloadable, web, and mobile platforms for enhanced trading. You also do not need any minimum deposit to have an active account with TD Ameritrade. However, for your account to be enhanced for margin trading, you will be required to make a minimum deposit of $2000. This deposit can be made either in stocks, cash, or other tradeable securities for the margin account. Additionally, TD Ameritrade comes with advanced features, including live streaming news, real-time quotes, research tools, and charting abilities through its Thinkorswim platform that facilitate a better trading experience.
Charles Schwab is another popular trading platform for a wide range of tradeable assets, including mutual funds, bonds, options, stocks, and ETFs. Although opening a Charles Schwab account is free, you will need at least $5000 to have an active margin account. Also, for you to short sell at Schwab, a minimum of 50% of the total value of the stocks is required. This platform also offers educational and research resources that are suited for investors of all levels.
Founded in 1985, Firsttrade has accumulated $2.3 billion worth of assets. Firstrade is known for offering free trades for almost all the assets offered in this platform. Firstrade has no commission charges when you trade mutual funds, options, stocks, and ETFs. The platform’s Navigator has made it possible for investors to place orders, manage an account, research, and receive market updates simultaneously.
Risks Associated with Shorting Stocks
Although shorting stocks come with plenty of benefits, they also pose risks that can be costly to the investor. Risks associated with short selling stocks include the following;
Short Squeeze – This is the risk of accumulating massive losses due to a rise in stock prices, resulting in the termination of the short. When the value of stocks rise, short sellers are thrown into a panic mode, forcing most of them to go back to buy the invested shares. As a result, demand for stocks spikes, causing stock prices to increase even more.
Margin Call – When the marginal account of an investor falls below the required threshold, a broker may demand the investor to give additional cash or assets for the account to reach the required maintenance margin. This demand is known as the margin call. The maintenance margin, in this case, refers to the minimum amount that a margin account should have for short sells to be executed. Failure to adhere to the margin call may force your broker to liquidate your position, which eventually locks in your loss.
Demand for Return – This is the risk that a broker may demand immediate repayment or return of borrowed stocks. This demand is often given a timeframe of up to three days, after which the broker may consider liquidating the investor’s short sale. This may force the investor to unwind their shorting position, which happens at a possible loss.
Market Risk – This is the most notable risk associated with shorting. It refers to the risk that a rise in the share price of a stock may result in massive losses. A spike in market prices may be as a result of political stability and favourable announcements by government heads or central bank.
Metrics to Use When Short Selling Stocks
It is possible for traders to track activities around a given stock and identify potential assets for short selling through shorting metrics. This section addresses metrics that investors should use when shorting stocks.
This metric measures the total shares that investors have shorted but not yet closed out. Basically, short interest shows the number of shares that are held for the purpose of shorting. The higher the short interest ratio, the greater the potential of a stock to short sell.
Percentage of Float
Float refers to the amount of stocks available to the public for trading. This measure is used to compare the potential of various sectors and companies as far as shorting of stocks is concerned.
Stock Loan Fee
This is the cost that investors will have to incur to borrow stock for shorting. When this cost is high, it implies an increased demand for the stocks in question. The higher the borrowing cost, the lower the profits that investors are likely to gain from shorting stocks.
Shorting is an attractive way for investors to make money. Short selling stocks is primarily based on speculation. This means that investors will earn substantial returns if the value of a stock drops to the anticipated levels. Unfortunately, shorting may also result in massive losses when the market trends move against the trader’s speculation. It is, therefore, fundamental for investors to employ strategies and various metrics, such as short interest and stock loan fee to be on the safe side when shorting various assets.