Short selling in the stock market is one of the most common strategies to make a profit from the stock market. It relies on investors buying shares at a low price and then selling them at a high price to increase the profit. However, short selling, like all other investment methods, has advantages and disadvantages. We will talk later about how to short sell shares in the stock market and how to make a profit from it.
What does short selling mean in the stock market?
A short sale in stock market trading is a transaction in which an investor sells an underlying asset that he does not own. The short seller speculates that the price of a stock or other security will decline in the future and that the stock will be cheaper at some point in the future.
How does short selling work in the stock market?
In securities trading, a short sale is a traditional future transaction in which the settlement takes place at a specific date in the future. Simply put when an investor trades in shares short, he sells securities that he does not own, so he borrows the shares and pays a fee for them.
The short seller speculates that prices will fall so he assumes that he will be able to buy the borrowed shares cheaper on the stock exchange later to return them to the lender. The difference between the sale price and the subsequent purchase price minus the borrowing fee is his profit.
With short selling the seller takes on a very high risk, because if the prices of the borrowed shares do not fall as expected he still has to stock up on the corresponding securities at the end of the loan term to meet the delivery obligation.
Regardless of whether the stock prices have fallen or not, the speculator is obliged to close the trade on the agreed date by buying the borrowed shares on the stock exchange and then handing them over to the broker.
The profit or loss from short selling arises from the difference between the sale price and the subsequent purchase price. To make an actual profit, the subsequent purchase price must be lower than the original price. A fee is usually deducted from this profit. For losses to occur, the reason for this is that the short seller must have liquidated his short position in time in order to return it to the lender.
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Short Sale Example
How short selling works can be illustrated with a simple example, suppose the short seller (who could be a hedge fund or private investor) borrows 500 shares of Company X from a broker at $100 each and sells them short on the stock exchange, over the course of the borrowing it decreases The share price is at 20% and the short seller buys the shares at $80 to return them to the broker on time, in this case the seller earns €20 per share for 500 shares, this corresponds to a return of $10,000, from which the broker’s borrowing fee must be deducted.
In a second example: If the short seller’s expectations are not met, and the share price of the short-chosen company rises 20% to $120 because of a sudden takeover offer, the short seller is now forced to buy the shares at that high price and realizes a loss of $20 per share plus the borrowing fee which he has to pay to the broker.
Why sells short?
Short positions are generally taken for two purposes:
1. Speculation on falling prices:
whoever sells stocks wants to benefit from price setbacks, as the investor bets that he will be able to obtain borrowed securities in the market later in order to generate revenue from the difference between the original selling price and the subsequent purchase price.
2. A hedge transaction:
short sales are also used to protect other positions from losses in phases of declining stock prices. Hedge funds are particularly known for this investment strategy. In stock market parlance this is also referred to as “hedging”.
How to sell as a private investor?
Private investors also could enter short positions. If you want to bet on falling stock prices you can do short sales, for example by trading derivatives such as warrants or CFDs. Entire indices can also be shorted using so-called mutual funds. Inverse trades that determine the performance of the underlying index in the opposite direction.
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What are the risks of short selling stocks?
In the case of long positions, the price can decrease by a maximum of 100% and this corresponds to the total loss of the invested capital, on the other hand, with short selling the risk of loss is unlimited because the price of the short security can also increase indefinitely at least from In theory, therefore, the inevitable buyback of shorted shares can be very expensive.