Short selling

DEFINITION of Short selling

Short selling represents the selling an asset that you do not currently own, in the hope that it will decrease in value and you can close the trade for a profit.

WHAT IT IS IN ESSENCE

It is also known as shorting.

Short selling is a trading strategy that seeks to capitalize on an anticipated decline in the price of a security. Essentially, a short seller is trying to sell high and buy low.

The traditional way to profit from stock trading is to “buy low and sell high”, but you do it in reverse order when you wish to sell short. To sell short, you sell shares of a security that you do not own, which you borrow from a broker. After you short a position via a short-sale, you eventually need to buy-to-cover to close the position, which means you buy back the shares later and return those shares to the broker from whom you borrowed the shares. You can make a profit from short selling if you buy back the shares at a lower price.

When you trade stocks in the traditional way, the maximum amount that you can lose is your initial investment. However, when short selling stocks, your losses are theoretically unlimited. Since the higher the stock price goes, the more you could lose. You will pay interest only on the shares you borrow. Hence, you can short the shares as long as you meet the minimum margin requirement for the security.

The hope behind shorting a stock is that the stock price will decline or that the company will go bankrupt, leading to total ruin for the equity holders. The short seller can then buy the stock back at a much lower price, replace the borrowed shares. And pocket the difference, adjusted for any dividend replacement payments that were required along the way.

As a condition of a short sale transaction, the short seller promises to replace the borrowed stock at some point in the future, while making dividend replacement payments out of his or her own pocket to cover the dividend income that is no longer available on the original shares.

HOW TO USE

Short-sellers tend to use this strategy for either speculation. Of course, in the hope that downward price movements return a profit or as a method of hedging.

Short selling involves a three-step process.

1) Borrow shares of the security, typically from a broker.

2) Sell the shares immediately at the market price.

3) Repurchase the shares (hopefully at a lower price) and return them to whoever you borrowed them from. After all this, you will pocket the difference if the share price has fallen but will have lost money if the price went up.

Short selling is risky for a number of reasons. First, an investor is revealed to theoretically unlimited losses if the underlying stock rises instead of falls.

Second, a sharp rise in a particular stock can trigger a large number of short sellers to cover their positions all at once. Short covering can push share prices even higher. And cause even more short sellers to cover their positions. Prospective short sellers should be wary because volatile stocks with large short interest, are particularly subject of this phenomenon.