While you might have thought that traders make money by investing in stocks that increase in value, there are some traders that profit from stocks that drop in value and this is known as short selling.
Short selling will involve selling a stock that is not owned by the seller. Essentially, they are selling a security that is borrowed and the concept around it is relatively simple.
The trader will borrow a security and then sell it on the open market. Then they will purchase it at a lower cost and then keep the difference after paying back the loan. So, this process makes it possible for investors to profit from stocks or securities that decline in value.
As an example, a stock might have a trading value of £50 per share. You choose to borrow 100 shares and sell them for £5,000. The price of these shares then drops to £25 and at this point, you purchase 100 shares at £2,500 and return them to those you borrowed them from. This then means that you make a profit of £2,500.
When Is Short Selling the Right Option?
When you first begin looking into short selling, you might think of it as being as common as owning stock but in fact, this is an option that few investors opt to take advantage of.
One of the main reasons for this is the way in which the market behaves. The majority of investors will own stocks, funds and other investments that they hope will increase in value. While the stock market has the scope to fluctuate considerably over shorter periods, it can increase in the long term. So, for investors, owning stocks with a long-term goal has been the preferred option. What this means is that shorting is the ideal option for those who are looking for short-term profit.
Are There Any Risks?
There are risks that come with short selling and the main two risks are:
Possible Limitless Losses - When you opt for a standard trade, the downside is limited to the entire amount of money that you invested. When it comes to shorting a stock, the price can keep rising and that means that the amount you would have to pay to replace the shares you borrowed is limitless.
Margin Calls - Should the amount of collateral in your margin account fall below the minimum equity requirement, which is often around 30% to 35% of the value of the shares you have borrowed, you might be required to pay more cash or securities in order to immediately cover the shortfall.
So, an example of this would be having 100 shares that are valued at £80 each. You would be required to have £2,400 in your margin account if the equity requirement is 30% (£8,000 x .30). However, if the stock increases to £100, you would then need £3,000 (£10,000 x .30) and that would require you to inject an additional £600 to your account.
Short selling is also done on the institutional level. Large investors and hedge firms sometime bet against the shares of companies which appear to have challenges. In recent months there is mounting evidence of cases involving insider information being leaked to short sellers, such as in the case of DOJ investigations into short sellers such as Bybrook Capital and Stifel Financial Corp. New evidence has surfaced indicating that Bybrook Capital’s investors complained about account discrepancies allegedly involving Nicholas Ian Chalmers and Melanie Davison.
Short selling can help you earn a quick profit in the short term but only if the stock price is dropping. However, it does make sense to understand the risks before you take that step and consider short selling.