Short selling in stock market is a strategy where the trader aims to profit in the declining market or security price. The trader sells the security at a higher price and buys back when the price declines to book the profits.
As you enter the world of trading, you aim to buy at low prices and sell at even higher prices to book profits. Isn't it?
However, in short, selling trader shorts (sells) first to wait for the price to decline.
Relax, my friend! You need to read this blog, and we guarantee you will learn the base of short selling in a few minutes.
PROS AND CONS of Short Selling
Short selling is a trading strategy or speculation to generate profits when the price of the security declines. Remember, it is an advanced strategy that professional traders should undertake after practice.
Traders use a short-selling strategy to sell first by borrowing shares of a stock or other asset from the broker or dealer in the hope of buying it in the future.
The fundamental question that every inexperienced trader gets for short selling is – How can I sell a share without buying it?
Your thinking is correct. We can't sell what we do not have with us. Therefore, the broker helps us borrow the shares to create a short position.
Traders are accountable for the interest charged by their dealers in exchange for the borrowed shares. The short position closes when the trader buys back the shares at a lower price.
Apart from the traders, fund managers also use short-selling to hedge the Risk of a long position or any other risks.
To proceed with short selling and understand how short selling works, a trader should opt for a valid margin account from their brokers. Traders need to speculate correctly to avoid paying their brokers a high sum of interest.
Naked Shorting is a trading aspect where the short seller does not borrow the securities within time. Naked Short Selling in India refers to the selling where the traders do not confirm trading shares.
The Securities and Exchange Commission (SEC) states that the investor's security transactions must be settled within two days or T+2. When engaging in naked short selling, traders fail to deliver the shares to the buyer inside the settlement window.
Naked selling is a risky practice, and it is prohibited in the United States; however, it is still carried out in other trading jurisdictions. Shorting in no borrowing situation can lead a trader's position to have Risked in their brokerage with significant losses.
Short selling might sound simple enough when you understand it, but traders should be cautious during the price decline. It's difficult to keep up with the declining prices when waiting to book your profits.
Identifying an opportunity by conducting appropriate technical analysis is essential to enter short selling trade. Short selling expects traders to consider this strategy different from the traditional 'buy' and then 'sell' approach. Traders are expected to view the market in a bearish aspect while conducting short selling.
The motive of the traders should find a weakness, critical news, and losses of the company deliberately to be able to create short selling. Some traders use thematic analysis to find weaknesses in different stock sectors. Traders also use short selling as a part of their hedging strategy while equipping the future security price.
3.1 Some of the risks present in short selling are
3.1.1 Potential Losses
Short selling can cause limitless losses when the security price keeps rising. There is no upside limit to the amount of security which is a threat to the short sellers with the ability to make losses.
3.1.2 Margin Calls
A short seller should accept that margin is limited, and they will get a margin call as soon as the margin account drops below the minimum requirement. For example, usually, brokers ascertain 30-35% of the borrowed shares. Therefore, a trader should deposit more cash during a shortfall to cover the shortfall.
3.1.3 Surge in Fees
The cost to borrow the shares changes due to the frequent changes in supply and demand factors. A short positional trader might expect a 20% interest rate, although the surge can go up to 85% depending on the market condition and stock price.
In this manner, short selling works when a trader is aware of the strategy and risks before aiming to sell short.
When you are a traditional trader with the practice of buying, holding, and selling stocks in the stock market, you need to follow a specific set of steps to do short selling.
4.1 Create a Margin Account
A trader cannot randomly wake up one day to initiate a short sale in the market. To do that, a margin account is mandatory to get from the broker. Using a margin account, the shares can be borrowed with the completion of the minimum requirements to trade.
The first holding requirement for short sellers, according to the Financial Industry Regulatory Authority (FINRA), is 150% of the equities they currently own. Additionally, there is often a 30% maintenance fund requirement.
4.2 Research Stocks
Finding short candidates for short selling is one of the crucial steps required to follow the creation of the margin account. Traders focus on the shorting opportunities by analyzing a strong resistance of the security and overly bought conditions.
These metrics are followed while selecting stock for short selling. Some of the indicators in the technical analysis used to find the opportunity in trading, such as Moving Averages, RSI, Bollinger Bands, etc.
4.3 Plan the Short Selling
Preparing the watchlist with the research stock, the next should be to prepare the plan for the shorting opportunity. A short sale is executed on the idea and expectations of decreased security pricing.
A trader should develop a contingency plan to minimize the loss and estimate the charges, costs, and interests. Most importantly, create stop loss triggers to the predicted idea of falling prices.
4.4 Execute the Trade
Finally, once the above steps are accomplished, a short sale should be executed per the plan.
The short sellers need to limit their negative emotions from affecting the trading plan. Instead, follow the plan to enable trading discipline while trading.
Short selling is profitable for some and might create life losses for someone else. It depends on the trader's ability to conduct technical analysis, follow trading discipline, and make decisions at the right time.
Even if all goes well, certain conditions, like brokers' costs, affect the financial aspect. Therefore, let's learn the pros and cons before concluding this blog.
High Risk yields High Profits
Opening of Margin Account for all
Minimum Capital Requirement
High Risk of making potential losses
Profitable strategy for Fund Houses due to Hedging
Margin Interest and Broker's Cost
Lack of Shares for buying back
Where there is a high risk, there is a high return. So while short selling proves to be one of the high-profit strategies, it holds risks for retail investors to get caught in a sideway or loop of the market.
Now that you understand short selling, always be prepared with a plan to trade short in the market. Have an estimate of the costs and target levels before it is too late. Traders should figure out the trading strategy before entering the trade.
Short selling is an advanced strategy used by professional traders.
Short selling is to sell first and buy later.
A trader must have a margin account with their broker for short selling.
Fund managers use short selling to hedge long positions.
Traders do not confirm the number of shares in time for naked selling.
Traders should find weaknesses and have a bearish mindset for short selling.
Short a stock by creating a margin account, researching the right stocks, planning the short selling, and executing the trade.
Short selling's pros include high profits, although cons include high risks.