What is shorting a stock?

If you’d like to know how does shorting a stock work, you can turn to the feature film The Big Short, which is based on real events. Its prototype was the 2001 record of the largest profit per week from trading. The uniqueness of the situation is that at the same moment, millions of investors were losing money on the collapse of the real estate market and associated banks.

Principles and features of margin trading 

The principle of classical stock trading differs little from ordinary stock speculation. An investor or trader buys an asset, waits until the price rises and sells with a profit. With a physical purchase, dividends become additional income, if the company accrued them during the period of ownership. If you are wondering what is shorting stock, it’s a way to make money on stocks that are not available, potentially profitable speculation in virtual assets.

What is a short position – principle and key concepts

You can make money on physical investment in stocks only if their price rises. When a trader wants to short a stock in the stock market, a trader earns on a fall in asset value. The point is to sell the asset at a high price, and as soon as the price drops, buy it back with a profit. The main nuance of the short game is the preliminary loan from the broker – that is, the trader initially sells the borrowed papers, and after conducting transactions returns it, keeping the profit. A simple practical example will clarify the process:

  1. You plan to short 10 shares at 5,000 each. At the same time, all forecasts indicate that the value of your selected asset is falling, that is, the price will decrease.
  2. Securities are borrowed from a broker under the obligation to return in a short period (short).
  3. Borrowed shares are immediately sold. The trader’s conditional profit is 5,000, and the shortage is the very 10 shares that must be returned. But the price falls, and by the evening the same assets appear on the market for 4,500.
  4. The trader redeems them from the market (the same 10) and returns them to the broker.

Just under 5,000 remains on hand, since, in addition to the difference in cost, the broker’s commission for borrowing and paying for the transaction was debited from the account. This amount is income.

Features of borrowing shares from a broker

In the example of how to short stocks, everything looks simple, but there are subtleties. Margin lending is available only with specific collateral – the amount by which losses can be repaid. If trading also uses leverage, which increases both income and risks, the amount will be significant. Funds sufficient for repayment will be blocked at the time of margin lending processing.

Two concepts are important here – the initial and final margin. Initial is the starting supply for the transaction. To derive a ratio, asset value is multiplied by the risk rate. The minimum margin is 1/2 of the initial margin, which is the minimum required to maintain a position.

To determine the loan limit, the broker calculates the value of the liquid portfolio – subtracts the client’s debt from the price of the client’s assets, which will go towards paying for the borrowed shares if and when the trader’s total balance is in the red. That is why it’s not worth it to borrow too much and use excessive leverage – the broker will receive his money in any case.

For operations, the broker will take a commission, as in normal transactions. But with a loan, an additional percentage will be taken – a fee for keeping a short overnight. If a trader “borrowed” shares from a broker, sold them on the same day, was able to buy cheaper and repay the debt to the broker, then no interest is charged. If the process stalled and all transactions couldn’t be conducted on the same day, an additional commission will be charged – the daily loan payout.

The easiest way to hedge against risks is to set reasonable stop losses. If the asset price still went up despite all the forecasts, a robot will simply close the deal. As a result, the loss when you sell a short will be insignificant, and can typically be covered by the next transaction.

Practice and risks of short trading

The secret to the success of short trading is the timely detection of the uptrend’s deterioration. 

These “symptoms” include:

  • a long uptrend without rollbacks and the first attempt to drop;
  • the appearance of a gap down on high volume or large sales without recovery attempts;
  • failed attempts to go above the 50- or 200-day SMA.

If all signs are present, you can short stocks. The advantages are risk hedging, the prospects for earning with a minimum starting capital and minimal restrictions.

By all means, please remember the risks associated with stocks that are shorted. Short-term positions are considered the most unpredictable. To work with shorts, you need to have a good command of fundamental and technical analysis and have a great degree of self-control.

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