What does a stock shorting mean?
When the market goes on a beer run and the investors feel that the price of some stocks might crash, they resort to shorting. Stock shorting is an act of borrowing and selling shares that you do not own to an investor. Investors practice stock shorting when they feel that the share prices are likely to dip.
Investors can earn through short selling stocks or different such financial securities when the prices go down. To create such an opportunity in a bearish market, securities have to be bought from a trading company that actually owns them before selling them to a potential buyer. The margin between the purchase and selling price is then the investor’s profit.
Basically, every time an investor short sells, there is an expectation that the price will fall further and when the investor buys the stock back at a lower price, they could earn a profit from it.
For instance, you find the price of a particular company’s stock very high, say at $100 per share. Hence you choose to borrow 10 such stock shares from your trading company to be sold at $1,000. After you’ve bought these stocks, the price tumbles to $90 bringing the total amount down to $900. In this case, you return these stocks to the trading company and keep the balance of $100 as your profit.
When does stock shorting make sense?
If you’ve been wondering what stock shorting means and have now understood how it works, it is only common to feel that this strategy is pretty common. But, this strategy is not something everyone uses.
The primary reason why this happens is that investors enter the market expecting the stock values to rise. No one wants to invest their money to watch it dip and not grow. Of course, in the short span of time, there can be some fluctuations in the market but usually, investors opt for long-term strategies because the prices go up after some time has passed. If you are a short-term trader, you may find short selling rewarding but if you want to stay in the game for a longer run, there’s little money to be made here.
There’s no doubt that short selling is basically the opposite of most trading techniques but it offers a good chance of making money and earning when a majority of traders are experiencing a fall in the prices. Impact on Dubai Real Estate Post Expo
How does stock shorting work?
Here’s another example to explain how shorting actually works.
You choose a stock whose price seems to be unusually high. You approach your trading company asking them to lend you 10 odd shares of this stock. When you sell these further at say $20 each, you have $200 in your kitty. However, remember that the 10 shares you borrowed now have to be returned. Thus, you wait till the market dips further to a point where the per-share value drops to $10 each. Now when you return these assets, their total value is only $100, and thus the remaining $100 is your profit.
Risk of stock shorting
Short-selling is a strategy best suited to seasoned players. Making a profit is all about making the right trading calls. In this particular case, the chances of losing to improved market movements are much higher than making a profit by expecting the prices to fall. When you buy a stock, there’s a risk of losing what you invested but that’s a sum you’ve already paid and in some sense, you’re fully aware of the magnitude of the loss you could incur.
If the opposite happens, that is the value of the stock rockets up, you could potentially earn a lot. Long-term investors often enjoy the benefits of long-term investment strategies as then they can witness their money grow exponentially. However, selling short in a bullish market may put you in a tough spot because then you cannot estimate the amount of loss you may have to bear over time.
Selling stocks short does not imply that you would be able to buy back the stocks as and when you please at the kind of price which meets your expectation. Stock prices are also extremely volatile and thus when you’re investing, it is wrong to expect the prices to go from point A to C. Be sure that you know of all the possibilities that you may have to face. In the following cases, you could potentially suffer losses if:
- There are no sellers in the market
- There are multiple buyers in the buyers in the market because well, there are other people selling short too!
Shorting vs regular investing
Shorting a stock can be very different from typical stock market investing strategies. This comes with its own unique set of regulations. This is also inclusive of the rule that makes sure that short sellers are not able to manipulate the market by driving a dip. To be honest, there are plenty of things that could go wrong with short selling and hence, the possibility of making a loss is significantly high. Hence, this strategy can be more strategically used by experienced players.
Alternative to shorting
To close, a possible option of mitigating your losses associated with shorting is to purchase a put option on stocks. The advantage of a put option is that you have the choice to sell the stock at a strike price, which is a predetermined price prior to the expiry of the contract. Thus, say you use a put option that has a strike price of $100. However, you see that the price of the stock has dipped to $60, so you can choose to purchase shares for $60 and sell them further at $100 to make a profit of $40 from the price dip.
Thus, the put option comes close to shorting and it is possible to lose only what you’ve paid for as in any traditional stock purchase. However, your trading options are not limited to what we talk about in this article. We encourage you to be a smart investor and carry out your own research to understand the market better and see what works for you when it comes to shorting a stock.