Understanding the Basics of Short Selling in the Stock Market

There are two main ways to perform in the stock market. The first way is buying stocks and selling them afterwards. This is called a long position. The second option is selling stocks that you borrow, then buying and returning them to your broker when the price drops. This is called a short selling.

With playing long, things are quite clear: the trader buys the number of shares they need and waits until their price rises enough, and sells them. The difference between the buying and selling price makes the profit.

When we're talking about short selling, there are many more details to take into consideration, and today's article is dedicated to these.

Where and why stocks are borrowed?

To sell stocks or assets, the trader needs to own them. If they do not own shares in the company of their interest, they can borrow them from a broker.

Brokers are legal entities licensed to give physical people access to the financial markets. The trader borrows stocks from the broker, thereafter sells them at the current price. If the price of the stocks falls, then a trader has better conditions to buy them back and return to the broker. The difference between the selling and buying prices is the profit. If the price of the stocks rises and a trader buys them back on a higher price – they will get losses on the same difference between the selling and buying prices.

What is leverage and what it is needed for?

The trades one can make on falling prices are limited by the sum on one's balance and the number of shares one can actually sell. If traders are aiming at trades that cost much more than what is in their current balance, the broker can provide them with leverage, i.e., a loan, for a certain commission fee.

The maximum leverage is set by the broker, and the trader chooses the most suitable option available. By working with leverage, the trader must be very careful and aware of the possible risks.

What shares cannot be used for short selling?

• The shares that have declined noticeably – the exchange blocks all sales of this stock to protect the company from bankruptcy. You can still buy these shares and close your position by selling them later
• The broker does not have shares in the company of the trader's interest
• The shares that the broker chooses for short selling are not liquid in the market

Advantages and drawbacks of short selling

Advantages:

• Opportunity to work in the descending market
• Risk diversification
• The expansion of options for trading

Drawbacks:

• Possible loss if the price of shares will not fall
• Unlimited losses
• Possible loss if the trader misses the dividend cutoff

Example of a successful short selling trade

The trader decides to open a short selling trade for the shares of Amicus Therapeutics Inc. (NASDAQ: FOLD). By clicking the Sell button, they send the broker an application for a short selling trade.

The broker processes the query and lends the trader 100 shares for $12.5 each. The deposit for the open position is $1, 250. This is the amount received by multiplying the number of shares by their price: 12.5 * 100 = 1,250. The broker's commission for opening a position is $0.9.

15 trading sessions later, the FOLD share price drops to $8.7, and the trader decides to close their position. By clicking "Buy" or "Close position", they send the broker a signal that the position is to be closed. The sum of the purchase is $870 – 8.7 * 100. The broker's commission for closing the position is $0.9.

The trader’s balance is $378.2, which is the difference between the selling price and the buying price of Amicus Therapeutics shares minus the broker's commission fees: 1,250 - 870 - (0.9 + 0.9).

Note that if FOLD quotes had headed up, the trader would have needed more money to buy the sold shares back and return them to the broker.

Example of a losing short selling trade

The trader decides to open a short selling position in Alcoa Corporation stock (NYSE: AA). The broker processes the application and lends the trader 100 shares for $18 each. The deposit for the open position is $1,800, and the broker's commission for opening a position is $0.9.

12 months later, the share price of Alcoa Corporation rises to $76, and the trader decides to close the position. The sum of the purchase is $7, 600, and the commission fee of the broker for closing the position is $0.9. The trader has lost $5801.8 which was withdrawn from their balance.

Summing up

When using short selling, the maximum income of the trader is 100%, while the maximum loss is, theoretically, unlimited. The only way to stop losses is forcibly closing the position by way of a Margin Call.

Short selling trades require much care, especially for beginner traders. It requires thorough market analysis and evaluation of the prospects of a decline. Trades are to be under control at all times, with all the rules of risk management followed strictly to limit possible losses.