What is Short selling and it’s types? Explain everything about short selling.

Just picture it: You’re a detective who suspects that a particular company’s stock is going to fall soon. You don’t already have any shares, but you choose to go along with your suspicion. You get shares from a broker, sell them at once at the market price, and then just wait. This is short selling – a bet against a stock. Now, if your guess is right, and the stock price declines, you buy the shares back at the cheaper price (covering your short position), give them back to the lender, and take the difference as your profit. On the other hand, if the stock price raises, you have to buy the shares at a higher price, which turns into a loss for you. The short-selling process has many varieties, including regular short selling, as well as complex practices involving options and futures, with each offering a different return-on-investment ratio. It’s a risky business where you are, in a way, betting on the downfall of a stock!

What is Short selling?

Short selling is a high-level tactic for investment in which case an investor takes a stock of a company, which he thinks will soon lose its value, on a loan. He then sells the stock immediately for the current price in the market. The investor’s aim is to buy back later the same number of shares at a lower price and return them to the lender. The profit of the investor is the difference between the price at which the shares were sold and the price at which they were bought back, thus the investor earns money from the stock price decline. On the other hand, it is a risky strategy since, if the share price rises instead of falling, the investor can sustain huge losses, as he will still have to buy back the shares to return them, regardless of the price.

The Basic Mechanics of a Short Sale

• Borrow the shares: You borrow shares from someone who owns them (usually via your broker, who borrows from another client or a prime broker).
• Sell the borrowed shares immediately: You sell them on the open market at the current price and receive cash.
• Wait for the price to drop (hopefully)
• Buy back the shares: (cover the short) You buy the same number of shares at the lower price.
• Return the shares to the lender You give the borrowed shares back. The difference between what you sold them for and what you bought them back for (minus fees and interest) is your profit.

Simple Example

• Stock XYZ is trading at $100.
• You borrow 100 shares and sell them → you receive $10,000.
• Price drops to $70.
• You buy back 100 shares for $7,000 and return them.
• Your profit = $3,000 (before borrowing fees, interest, and commissions).

If the price rises to $130 instead:

• You buy back at $13,000 → you lose $3,000.

Types of Short Selling:

Naked Short Selling:

• This is a practice that is usually more extreme and frequently illegal.
• The investor in this case sells shares without borrowing them first or checking that they can be lent out.
• In such a case, the seller might not be able to provide the shares to the buyer, and this might cause a disturbance in the market.
• The legislation laid down by financial regulators is, in most cases, either very strict or prohibitive regarding this matter.

Covered Short Selling (The Standard Method):

• This standard and legal method of short selling is what the majority of people reference.
• Initially, the investor borrows the shares from the broker (who takes them from the account of another client) prior to selling those shares.
• The short position is “covered” since the seller has found and guaranteed the shares to borrow, thereby promising they can be handed over to the buyer.

Speculative Short Selling:

• The only reason for this move is to gain a profit from the anticipated drop of a stock’s price.
• This is the primary motivation for retail investors to participate in short selling.

Hedging / Protective Short Selling:

• This is also an investment protection measure that acts like insurance.
• Let’s say an investor holds a significant number of tech stocks; in this case, he/she might short sell a tech index. In the event of an overall fall of the tech sector, the profit from the short position would be used to cover the losses from the main portfolio.
• However, the intention in this case is not to mainly gain profit, but to minimize the risk.

Key Risks of Short Selling

• Unlimited Loss Potential: This is the primary risk factor. In the case of stock trading, your loss is limited to your investment. In shorting, theoretically, there is no limit to how high the stock can go if the price rises instead of falls. The loss you incur is equal to the difference between the much higher price you will have to pay to buy back the shares and your selling price.
• The Short Squeeze: This is an event when a stock that has been subject to heavy short selling unexpectedly increases in price. The frantic buying of short sellers trying to minimize their losses pushes the stock price further up, thus creating a vicious cycle that forces more short sellers to close their positions at huge losses.
• Margin Calls and Forced Closure: Short selling is executed through a margin account. If the market goes against you (the stock price goes up), the broker will ask you to deposit more cash or securities (a “margin call”) to keep the position. If you are unable to fulfill the call, the broker may buy back the shares to close the position, thereby realizing your loss.
• Borrowing Costs: Interest and fees to your broker are unavoidable when you borrow the shares. These costs will be accounted for during the period of your short position, thus, they will reduce the profit or will add the loss of the trade.
• The Dividend Risk: In case of a dividend payment by the company while you are shorting its stock, you, the short seller, will be the one who has to pay the dividend to the lender of the shares. This is an unanticipated cost that can even worsen a losing trade.
• Being “Right” but Too Early: You may be absolutely sure that a company’s stock is overvalued, but it may take the market months or even years to catch up. Meanwhile, the stock price could keep climbing, leading to huge losses for you before it finally drops as you expected.
• Regulatory and Fundamental Risk: Governments or regulators may change the rules (e.g., certain stocks cannot be shorted) that result in a sudden, sharp price increase. Alternatively, the company can be taken over at a high premium, and its stock price can increase overnight.

Who Can Short Sell?

• Almost anyone with a margin account (cash accounts usually cannot short).
• Retail investors via most major brokers (Interactive Brokers, Thinkorswim, Robinhood — though Robinhood restricts hard-to-borrow names).
• Institutional investors, hedge funds, market makers.

Conclusion

In a nutshell, Short selling is an investment strategy that allows you to make money from a decline in a stock’s price by first borrowing and selling its shares, and then repuying them at the lowered price. It’s a high-risk, high-reward scenario, where the chances of making a profit are considerable but so are the risks of losing a lot. It is important to know the various forms of short selling and the risks that come with them before getting involved.

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