The Basics Of Short Selling Stocks

The Basics Of Short Selling Stocks

The Basics Of Short Selling Stocks
‘Shorting’ or​ short selling refers to​ the​ selling of​ a​ contract,​ a​ bond or​ stock or​ a​ commodity that is​ not directly owned by the​ seller .​
When practicing short selling,​ a​ seller is​ committed to​ purchase the​ stock or​ commodity previously sold.
Short selling stocks means to​ take the​ stock from a​ broker on​ loan and sell it​ off to​ someone else .​
This is​ done so that the​ seller buys back the​ stock,​ when the​ price falls .​
The shares are returned to​ the​ broker from whom they were initially borrowed .​
The shorting profit or​ the​ difference in​ price goes to​ the​ seller .​
Short selling of​ stocks is​ a​ technique used by investors to​ capitalize on​ a​ probable decline in​ the​ stock price.
To understand this better,​ let us consider a​ company,​ say,​ ABC whose shares currently sell at​ $12 each .​
a​ short seller borrows 50 shares of​ ABC and then sells those shares to​ someone else at​ $12 per share,​ for a​ total of​ $600 .​
Now,​ if​ in​ future the​ price of​ shares of​ ABC falls to​ $10 per share,​ this short seller would then buy back those 50 shares at​ $500 ($10 multiplied by 50 shares),​ send back the​ shares to​ the​ original owner/broker and make a​ profit of​ $100.
Short selling is​ risky,​ if​ the​ price per share goes up instead of​ declining,​ as​ expected .​
Suppose the​ price per share of​ ABC goes up to​ $15 per share,​ then the​ short seller will have to​ cash in​ the​ previously sold 50 shares at​ $750,​ return the​ shares to​ the​ original owner and incur a​ loss of​ $150.
Shorting is​ a​ transaction done on​ margin .​
Most brokers do not agree to​ short selling stocks below $5 .​
This enables the​ investors and short sellers to​ indulge in​ the​ high-risk trading of​ stocks.
Some of​ the​ following market situations help to​ predict a​ fall in​ price of​ stocks: -
- Market indexes coming near the​ prior resistance levels.
- Market trend showing technically overbought levels.
- Restlessness before the​ announcement of​ a​ state’s government.
- Market vulnerability during scandals.
Large volume selling of​ stocks often result in​ short-term high profits .​
However,​ there are certain guidelines to​ be followed for successful short selling .​
They are:
- All stocks are not ‘short’ able .​
Generally,​ brokers inform a​ seller whether a​ stock can be used for short selling or​ not.
- Sellers must open a​ margin account for short selling .​
This depends on​ the​ minimum balances and cash reserves .​
Sellers are required to​ sign a​ contract agreement with the​ brokers to​ open a​ margin account .​
This agreement clearly states that a​ seller will follow the​ rules and regulations stated by the​ broker.
-Target bad-performance,​ overpriced companies,​ since the​ probability of​ a​ fall in​ the​ share price involves lesser risk.
- Traders and short sellers should use stop orders to​ protect their capital from loss .​
Generally,​ brokers prevent a​ seller from suffering loss more than the​ principal .​
They may either compel the​ seller to​ quit the​ transaction or​ they may deposit funds to​ increase the​ seller’s capital.
The short selling of​ stocks involves a​ lot of​ discipline .​
Sellers need to​ be proactive,​ alert and disciplined when shorting stocks.

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