Short Selling Stocks: Pros and Cons of the Investment Process

Written by 
Tommy Syrmolotov
/
December 22, 2021

Answer: Samsung

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shorting stocks downward graph - photo

Short selling in the stock market works on the assumption that the stock they short sell will decline in price. The theory and process are straightforward. Investors “borrow” a stock to sell it in the market at the current high prices. When prices fall, the trader repurchases it cheaper, and the repurchased stock is returned to the lender. The difference in prices between bought and sold stock is the trader’s profit.

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Don’t be fooled by how easy it sounds. Short selling is a sophisticated trading technique that only experienced investors familiar with stock market nuances should try.

The assumption in short selling stocks is that the stock price will decline, the investor will buy it back at a lower price and sell it to the lender. The difference between the buy and sell price is the trader’s profit.

Shorting a stock carries a significantly higher risk compared to the risks of passive or active trading. When an investor buys a stock, they risk only the principal stake in the trade. So if they bought a share for $100, they risk just $100.

However, the investor can lose a lot of money due to short selling risk. For instance, from the $100 share example, if the price doesn’t fall and rises to $250, the investor would lose $150.

What is Short Selling Stock?

In the short selling process, the short seller trades in borrowed stocks. The trading is done through brokers that offer this service. The broker buys the stock, they lend it to you, and you sell it. Once the stock is sold, your account with the broker is credited with the sale proceeds. You agree to buy the stock sometime in the future to return the loan to your broker. This process is known as covering the short.

Now let’s talk about why short selling is good. The broker earns a fee from the investors shorting stocks. The broker will also get any dividends issued during this time. As an investor, you buy stocks you forecast as declining in price based on market stability. If the price doesn’t fall, you are out by the transaction charges. If prices rise, you lose the price increase amount and the transaction fees.

The risks of short selling lie with the investor. The broker’s fee is guaranteed, and the broker can also force to sell the stock, known as covering the short at any time. This means that you buy the stock on the day the broker asks you. If prices on that day are higher than your short rate, you have to bear the difference, which is your trading loss.

However, most brokers ask for investors to cover the short if other traders want to short sell the stock. It is usual for prices to rise, and you can cut your losses in such a case. This happens because many traders shorting a stock push its price upwards.

Pros of Short Selling

Some of the primary advantages of short selling are as follows:

Little Capital Injection Needed

One of the advantages of short selling is that it allows investors to earn a significant profit without paying out the capital amount needed. Only the fee is required upfront, and the rest will be required by the deal’s close. This means that if the prices fall, you stand to earn a profit on an outlay of the broker’s fee.

Earn Money in Falling Markets

Shorting the market is the only way that investors and fund managers can make money in falling markets. If the market situation affects the stock price in such a way that stocks are falling, the only way to earn a profit is by utilizing shorts in the market.

Hedging a Portfolio

Having shorts in your portfolio allows them to hedge your portfolio if you have the stock in your portfolio. If you hedge against the stock falling, you don’t lose if the price drops and your investment is at risk. This can help in managing volatility risk for significant funds.

Cons of Short Selling

Some of the primary disadvantages of short selling are as follows:

Limited effectiveness

As investors investing on the assumption of falling markets is an impractical approach. Markets have both price rises and falls. This means that focusing on just the price falling limits the range of profit potential. The loss potential is also high.

High Risk

Due to the limited range of profits, the risks are very high. If the share price rises, the investor must bear the increased price differential and the broker’s fees. The short sale stock process can push a regular market adjustment and make it into a significant dip. The 2008 crisis provided many examples where using short selling pushed stocks into bankruptcy.

Some short selling stock examples that resulted in crashes are stocks like Bear Stearns in early 2008 and Fannie Mae, Freddie Mac in mid-2008. Short positions in Lehman Brothers in the fall of 2008 eventually initiated the financial crisis of 2008.

Advantages and Disadvantages of Short Selling

The pros and cons of short selling are summarized below:

short selling pros and cons table - photo

The risks in short selling seem to outweigh the short selling benefits. The only attractive feature in shorting is the hedging it offers to large portfolios from downside risk.

Short Selling Example with Explanation

Let’s see what happens when you short a stock in real life. Assume that the shares of AAPL are trading at $100, and you expect them to fall. You borrow 300 shares from a broker and sell them for the same price. You sell them for $100 and earn $30,000.

The shares fall to $70 in the market.

You now buy 300 shares for $70, which costs you $70 x 300 = $21,000, and you settle your debt with your broker.

Your net profit from the whole exercise is $30,000 - $21,000 = $7,000.

But what does short selling stock mean for investors if the stock price doesn’t fall? Let’s take a look at the opposite scenario:

Assuming that the shares of AAPL are trading at $100 and you expect them to fall. You borrow 100 shares from your broker and sell them at the same price. You sell them for $100 and earn $10,000.

The shares rise to $110 in the market.

You must now buy 100 shares for $110, which costs you $110 x 100 = $11,000 and settle your debt with your broker.

Your loss will be $10,000 - $11,000 = -$1,000.

Commission fees for the brokers would apply on both stages of the transactions, so many zero commission brokers do not offer short selling transactions.

Final Thoughts

Shorting stocks is a standard trading option for investors that have a lot of experience. It is also popular amongst hedge fund managers as it allows them to protect their portfolios from downside risks.

While keeping shares available to short can help create enormous profits, the investor also risks losing a lot of money.

If the market meets expectations, short sellers meaning to secure profits keep the amount leftover from the price they sell and the price they buy at. However, if the price of the shares rises, the trader will make a loss since they would have sold for lower and will buy at a higher price.

FAQ

What does sell short mean in stocks?

Selling short implies that the seller is selling stock that they don’t own at the time of sale. Experienced traders also know that trading short means that the seller expects the stock price to fall.

What is a short seller?

A short seller sells short stocks or looks to make a profit from selling short stocks.

Does short selling involve borrowing stock?

Short selling stocks involve borrowing as the short seller “borrows” the shares from the broker and sells them in the market. The cycle is completed when the seller pays off the loaned shares by repurchasing them from the market.

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