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October 18, 2019   FinTech and Alternative Finance, Fintech Services, Fundraising, Investing, Trading, Innovation and Resources   No comments

The Ins and Outs of How to Short a Stock

NCFA Guest Post | Oct 18, 2019

Beach trading 1 - The Ins and Outs of How to Short a Stock

During the history of the stock market its value has typically climbed. This has seen the most successful investors profit by buying shares in stocks at a low price and seeing their value increase steadily over time. Playing the markets can be risky however, as entire investments can be lost. But with the right set of circumstances stock prices can increase in value greatly over the years. This reward and risk trade off is appealing to lots of investors.

However, it is sometimes the case that investors believe that the value of a certain stock will decrease rather than increase. In such instances, buying these shares will result in the investor losing money. Short selling provides investors with the opportunity to profit from the price of a stock decreasing in value. This practice is also sometimes referred to as going short on a stock and provides the investor with a profit should the price of a stock decrease. However, if the price of the stock goes up then the investor will face losses.

How is shorting a stock done?

This process involves lending shares of a stock that you wish to sell from someone who owns it. Once borrowed, the shares can then be sold on the market, with the investor keeping the equity they raise. At a point in the future the investor will buy back the shares of the stock and return them to whom they were borrowed off.

The main reason for doing this is the hope that upon buying the shares back, their price has decreased. This allows the investor to buy them back with less equity than what the shares were initially sold for. Once the shares have been returned to the investor that they were borrowed off in the first place there will be some equity left over. It is this equity that is the investor’s profit from short selling the stock.

See: How Data-driven Strategies Can Improve Impact Investing Outcomes

As well as this, there are also numerous other scenarios in which short selling a stock can be helpful. One such scenario is for those investors that own a stock within a certain specific market, but wish to hedge their position against a risk that affects the entire market. By holding a short position on a stock that competes directly with the investors own stock it helps to keep the investor protected should the market take a downward turn. Investors that short sell a stock that they own will find that it is better tax wise than selling their own assets, particularly if it is anticipated that a decrease in the stock price will be reversed.

What does the process involve?

In order to successfully implement a short sell trading strategy an investor must first identify a stock that they wish to short sell. To do so an investor must have a margin account with a brokerage firm that has all of the required permissions to operate such a strategy. Working with the broker, an investor then borrows shares in the stock that they identified. The borrowed shares are then sold. Over a certain amount of time the stock will have either increased or decreased in value. Eventually the investor closes their position and buys the shares back that they had originally sold, returning them to the broker. If during this time the value of the stock decreased then the investor will pay less to buy the shares back, and the difference is kept as profit. However, if the price of the stock increased then the investor will pay more to buy the shares back, and the difference is the loss that they make.

Although it initially sounds quite complicated, it is actually more straightforward and simple than it sounds. Usually little work is required in the way of identifying someone to lend the shares from. This is a task that is typically done by the investors brokerage firm.

What are the risks associated with shorting a stock?

There are both pros and cons attached to shorting a stock. The main advantage is the fact that an investor is able to profit from the decrease in value of an asset. Without being able to successfully short sell, an investor has a very limited skill set by which they can make a profit. Other advantages include being able to make a portfolio that is market neutral and engineering a custom level of investment exposure.

However, as with any type of trading on the markets, there are some downsides and risks on how to short a stock. These include:

  • No loss limit – Theoretically there is no limit to the amount of equity that an investor can lose whilst maintaining a short position. Large financial losses are always at stake whenever an investor shorts a stock.
  • Special regulations – The regulations that surround short selling are much more stringent than those that affect traditional stocks trading. For example, during any period in which the market becomes volatile, limits can be placed on activities relating to short selling. The same restrictions would not be placed on regular stock trading activities.
  • Lack of control – There is a lack of control regarding when an investor is able to close their short positions. At any time the person that the investor initially borrowed the shares from can ask for them back, with the investor being forced to buy them back even if they do not want to.

See: 7 Steps to Short a Stock (TD Ameritrade as an example)

If the price of a stock increases very quickly then an investor could be left in a position where they face huge losses but is unable to cover them. This is why brokerage firms require short sellers to hold a minimum amount of equity in their accounts. In a case where an investor makes large losses, the brokerage firm may introduce a margin call, which forces an investor to close all of their positions, which are short and buy back the shares. For this, and for many other tasks, brokerage firms will charge a commission.

 

NCFA Jan 2018 resize - The Ins and Outs of How to Short a Stock The National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org

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