One method of trading stocks whose prices are falling is going short – simply call it short selling. This method speculates on the price decline of a security, but it is a pretty risky strategy that is only recommended for experienced traders. Indeed, even some experienced traders often go for the services of experienced portfolio managers to try and keep their risks low when shorting stocks.
Despite the risk involved, you will realize that shorting stocks is a pretty common strategy. In this post, we are going to take a closer look at what it is, identify key pros and cons, and demonstrate how to use shorting.
What is Short Selling?
Before we can look at the main steps of short selling in SDS trading, it is paramount to start by understanding what it is. Short selling is the process of borrowing a stock, selling it, and then rebuying to get it back to the lender.
Short traders do not actually own the stock they trade. Rather, they borrow it from a stockbroker in order to sell at the current price. The whole idea is to rebuy the targeted stock when the price falls down further and push the borrowed stock back to the owner.
The profit that you earn through shorting a stock comes from the difference in the cost of repurchasing the stock and the short sale the time of borrowing. It is paramount to note that when a trader shorts a stock, there is no limit to the amount that he/she can lose if the prediction turns out wrong. Therefore, it is very important to ensure you carry your analysis well to increase the prediction’s chances of turning out correct.
Pros and Cons of Short Selling
Short selling can be expensive, especially if you make the wrong guess about the price movement. A trader who purchases stock can only lose 100% of the outlay if the stock moves to zero. However, a trader who shorts a stock can incur more than 100% loss of the original investment.
The risk associated with shorting stocks is very high because there is no ceiling for the selected stock price, meaning that it can rise to infinity and beyond. Also, when the stocks are held, the trader is required to fund the margin account. Indeed, even when everything goes as planned in, you will still need to establish the cost of the margin interest to determine the profit.
It is paramount to note that a short seller might find it challenging to identify ample stocks to purchase, especially if other traders are also on the race of shorting the selected stock. Therefore, it is not uncommon to get sellers getting caught in a short squeeze loop if the market starts skyrocketing.
Here is a breakdown of the pros and cons of short selling
|There is a possibility of making high profits Little initial capital is required for short tradingYou can use leveraged investment in short trading It is possible to hedge against other holdings||Potential for unlimited losses linger if your prediction is wrong Short squeezes You are required to open a margin account You incur interest|
How to Short a Stock
Although the risk involved in shorting stocks in SDS trading live is pretty high, the steps that you need to follow are fairly straightforward. Here is a demonstration of how to go about shorting stocks:
- Step One: Open a Margin Account with a Broker of Your Choice
To short your stocks, you will need a margin account because you are able to use it to borrow stock to expand the investment options. Note that your broker might have some key questions on your ability to handle additional risks that might be associated with a short sale.
Depending on your broker, it might be possible to open an individual, joint, or corporate account to follow through on the short sale.
- Step Two: Ensure to Understand the Rules before Executing a Short Order
Notably, brokerage firms have different regulations on short sales, and it is paramount to understand them. For example, some brokers have limits of the number of stocks that a person can borrow. Therefore, it is paramount to read through the rules of shorting and understand them well.
If the rules of shorting are unclear or not presented, make sure to contact the broker to provide them. This will help you to understand shorting clearly and make the decision on whether to go ahead with it.
- Step Three: Direct the Broker to Execute the Short Sale of the Selected Stock
Notably, most brokerage platforms are fairly uniform and executing trades, such as buy, sell, or short order on a stock is pretty straightforward. However, the risk involved often makes some brokers to exclude “short” function, meaning that you have to contact them to short your stocks. Therefore, if yours does not, simply ask the broker to follow through and execute the short order.
- Step Four: Buy the Stock Back and Repay the Loan
Hopefully, your prediction was right. This implies that the price of the selected stock declined, and you got some profit.
Even if you lost money, you are still required to buy back the stock and repay the loan. In such a situation, you need to write a buy order, which will signal the broker that you want to cover the short sales through rebuy, clear the loan, and complete the shorting process.
After the short sale, the money left on the account from the transaction will be your profit. However, dividends that might be earned from the short sale deal belong to the broker.
If you are in SDS trading and would like to short trade, it is important to be extra careful because of its risks. If the trade goes against your prediction, there is a huge potential of incurring a huge loss. If you are new to stocks, you can successfully use the steps that we listed above, but it is better to use a professional to help you with the process.