How Short Selling Works

The stock market has been on quite a tear in the past eight years, and a large number of traders are betting that what goes up must come down. Inexperienced traders often stick to the objective of buying low and selling high, but short sellers recognize that selling high and buying low can be just as profitable.

WHAT IS SHORT SELLING?

At the most basic level, short selling is making a prediction that a stock will go down rather than up. Here’s how it works.

Short sellers borrow shares of stock that they do not own (typically from their broker’s street account) and sell those shares at the current market price. The goal is to re-buy those shares of stock at a lower price in the future and then return the borrowed shares to the lender. Short sellers are hoping they can profit off of the difference between the proceeds from the short sale and the cost of buying back the shares, referred to as short covering.

For example, short selling 1,000 shares of a $10 stock will land $10,000 in the short seller’s account. If the stock’s share price declines to $7 per share, the short seller could choose to cover his position by buying back 1,000 shares of stock at a cost of $7,000. Once he covers his position, the short seller has netted a $3,000 profit ($10,000 minus $7,000) from the trade.

It’s up to the broker to decide if the stock in question can be shorted, as they’re the ones who have to find shares to lend to the trader. Typically this is done automatically, and the broker will also automatically take their shares back as soon as a short is covered.

THE CAVEATS

While short selling can be an extremely handy and profitable tool for traders under the right circumstances, it also comes with its fair share of unique risks. To begin with, short selling is inherently more risky than traditional stock buying because the potential maximum profit and loss imbalance is reversed. When buying a stock, potential losses are capped at 100 percent of the original investment and potential gains are unlimited. When shorting a stock, the maximum gain is capped at 100 percent of the original investment, and the potential losses are unlimited.

Short selling also comes with a number of costs that typical stock buying does not. Short sellers are charged stock borrowing costs that can exceed the value of the short trade if a stock is particularly difficult to borrow. Because short selling can only be done in margin accounts, short sellers must also pay margin interest on their positions. In addition, short sellers are responsible for paying any dividends or distributions paid out by the borrowed stock. These costs can take a large bite out of any potential trading gains.

Finally, heavily shorted stocks are also subject to buy-ins, a phenomenon when the broker automatically covers a short position at the market price without notice. These buy-ins can occur when the lender of the stock demands it be returned, regardless of whether it’s an inopportune time for the short seller.

MAKING SHORT SELLING EASY

Lightspeed Trading recently added the Short Request module to its trading platform that allows users to easily find stocks they want to short. Just add…

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