Successful traders often earn huge profitability from stocks with rising values. However, some traders choose to benefit from the opposite, which is stocks declining in value. This strategy is called short selling. After this simple explanation of “what is short selling,” you might consider it pretty simple.
Published on 16 January 2023
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However, short selling is an advanced kind of speculative trading strategy primarily used by experienced traders and investors. It involves borrowing security with a tendency for falling prices and selling it in the open market. Later on, the same stock is bought at a reduced price than what it was sold at.
The profit coming from the difference in the selling and purchasing price can be used to repay the loan. Short selling has a high ratio of risk and reward. Proceed further in this article to increase your knowledge about what is short selling.
Understanding the Concept of Short Selling
A seller needs to open a short position to start with short selling because it is not possible to sell shares until they exist. To understand what is short selling, it is important for traders to know that the shares can be borrowed from a broker-dealer. It can be sold and can be bought back for a profit when the price goes down.
Once the traders buy back the share, a short position is closed. Traders will also have to bear the interest charged by brokers for bearing as well as commissions on trades. A trader will need a margin account to open a short position and will have to continue paying the interest as long as the short position is open.
Let us look at a short selling example to understand how a trader can benefit from this investment strategy. Suppose a trader finds a stock with a current price of Rs 50, but the price will go down in the next few months. The trader borrows 100 shares of that stock and sells it in the market.
Now, the trader is short of 100 shares because they sold something borrowed and not something they owned. But a week later, the stock fell to Rs 30. The trader can choose to buy back 100 shares at a low price to close the short position.
Therefore, the trader earned a profit from the short sale. But the profit needs to be calculated after considering interests on the margin account and commissions. Moreover, traders should know that it is not always possible to earn profits from short selling stock.
Benefits of Short Selling
Short selling might have high risks, but it also offers high yields. Once you understand what is short selling, you should also know that correct predictions are necessary for its success. When a seller correctly predicts the price moves, they succeed at gaining a high return on investment.
Using margin offers further leverage to traders as they don’t need to use much of their capital as an investment in the beginning. Short selling is one of the cheapest ways for hedging when you can do it the right way. It provides a fine counterbalance to other holdings in a portfolio.
Risks of Short Selling
Due to a wrong guess about the price movement, short selling can be highly costly to traders. As there is no ceiling to a stock’s price, the risk involves losing more than 100% of a short-seller’s investment.
While closing a short position, you might face trouble finding enough stocks to buy, especially when the stock is thinly traded, or a lot of other traders are shorting at the same time. Moreover, sellers can get lost in a short squeeze loop if a stock or the entire market starts skyrocketing.
Ending Note
Once you understand short selling meaning, you should know that timing is a crucial factor to consider while using this trading strategy. Stocks decline faster than they rise. A sizable profit from a stock can be wiped out in a matter of days or weeks due to a bearish development or some other issue. Therefore, it is crucial for a trader to enter a short trader at the right time to avoid losing out on profits.
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