Shorting

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21 Aug, 2024

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Shorting or short selling is a trading strategy wherein traders or investors borrow securities from a broker and sell them in the hopes of buying them back at a lower price shortly after. One can use this strategy for two purposes — speculation and hedging.

This strategy plays a crucial role in efficient capital markets. It offers various advantages by facilitating securities trading in the secondary market via improved liquidity and price discovery. At the same time, it positively impacts corporate governance and, eventually, the real economy. When there isn’t much optimism in bear markets, this strategy can generate significant financial gains.

Shorting Meaning

Shorting meaning refers to a trading strategy wherein traders or investors speculate on the decline in a financial asset’s price.
Shorting in finance can generate substantial profits for traders. However, this strategy involves potentially unlimited risks.
One must have a margin account to short securities. Moreover, the broker can issue a margin call if the equity falls below the minimum maintenance margin limit.
A crucial difference between longing and shorting is that a trader must buy a financial asset, in the case of the former. In contrast, one has to borrow and sell a security to short it.

Shorting in Stocks Explained

Shorting meaning refers to a trading strategy involving traders or investors borrowing securities from a broker and immediately selling them, expecting the price to decline in the future. Thus, individuals can make financial gains from an expected downward price movement using this strategy. Also, one may opt for short selling to hedge a long position’s downside risk in the same security or any related financial instrument.

Usually, experienced traders and institutional investors utilize this strategy for both hedging and speculation.

Let us look at how shorting works:

Traders open a short position by borrowing shares from a broker. Note that one must borrow the shares as they cannot sell the securities that are not there in their portfolio.
To close the position, traders must buy back the shares on the market — hopefully at a lower price than the amount they borrowed and return them to the broker.
Traders must pay interest or commission levied on the trades by the broker. Also, traders must open a margin account to enter a short position.

The Federal Reserve, the New York Stock Exchange, and the Financial Industry Regulatory Authority Inc (FINRA) have set a minimum balance that one must maintain in their margin account. This is the maintenance margin. If the account value of any trader or investor drops below the minimum value, the individual must add more cash to their account, or the broker might sell the position. One can open and close a trade with most brokers via regular trading platforms. Nevertheless, a trader must qualify for a margin account before engaging in short selling.

Examples

Let us look at a few shorting examples to understand the concept better.

Example #1

Suppose Jim borrows 20 shares of a company from a broker and immediately sells them in the stock market at $20 per share. As a result, he generated $400. If the stock price drops to $10 per share, he can use the $400 to buy back the 20 shares for $200 only and return them to the broker. His net income will be $200, excluding interest, commission, and other fees.

Example #2

The United States Department of Justice (DOJ) sent subpoenas to certain short sellers for trading information on organizations, including Microsoft, JPMorgan Chase & Co, and Amazon, as a shorting probe.

The Justice Department sent the subpoenas over the last few months requesting information concerning transactions in various blue-chip stocks. In addition, the United States securities regulator disclosed that it is considering measures requiring big institutional investors to disclose more details regarding their short position.

Risks

Shorting in finance has a very high risk-reward ratio. In other words, while this strategy can offer substantial financial gains, the losses can increase fast and indefinitely owing to margin calls. This makes it riskier than traditional investing in the securities market. Let us look at this example to understand the risk involved.

Suppose Adam, a trader, shorts Stock ABC at $20 per share. If the stock price drops to $0, he will earn a profit of $20 per share. However, the trade could go against him, and the stock price could surge to $40 or $60 or even higher, thus generating substantial losses. Thus, technically, there is no limit to the amount he can lose.

Besides the potentially unlimited losses, let us look at some other risks associated with shorting.

#1 - Short Squeeze

A short squeeze happens when a financial asset’s price rises, and suddenly all the short sellers scramble together to purchase the shares and cover their position. Each purchase drives the price higher. As a result, more short-sellers exit their position. This vicious cycle continues.

#2 - Margin Calls

If a shorted financial asset’s value surges significantly, the trader’s broker could issue a margin call. This would require the trader to add cash or equivalent financial securities to the account to cover the borrowed amount. If the trader fails to do so, the broker can sell their position, locking in the losses.

#3 - Change in Fees

The cost of borrowing shares changes frequently owing to demand and supply. For instance, a trader might log out of their profile one night with a 20% interest rate on their short position, only to find that it has gone up to 50% the next day. In a worst-case scenario, the value of the financial asset a trader shorted and the interest could rise together.

Shorting vs. Longing

Longing and shorting are two different terms that often confuse individuals new to the securities market. This is because both have distinct characteristics that one should remember taking a position in a financial asset. So, let us look at this tabular representation to find the differences.

Basis of Comparison	Shorting	Longing
Entry Action	A trader or investor borrows a financial asset from a broker and sells it.	A trader or investor buys the financial asset.
Reason For Waiting	Traders wait for the asset price to decrease.	Traders wait for the asset price to increase.
Exit Action	Traders buy back the financial asset at a lower price to make financial gains.	Traders sell the financial asset at a higher price to make a profit.

Frequently Asked Questions (FAQs)

1. How to do shorting?

Individuals can follow these steps to do shorting:
1. Enable margin trading on the trading account.
2. Find a financial asset to short.
3. Place a sell order.
4. Wait for the asset’s price to decrease.
5. Purchase the security and exit the position.

2. Is shorting a stock legal?

Short selling is a legal form of stock trading wherein a trader bets a stock’s price to fall. Generally, short sales used to manipulate stock prices are prohibited.

3. How shorting crypto works?

It is similar to shorting stocks or any other security. An investor borrows cryptocurrency to sell immediately at the current market price. Then, when the digital asset’s value drops, the investor purchases it at a lower price and makes a profit.

4. Does shorting a stock hurt the company?

Excessive shorting activities can cause a company’s stock price to drop suddenly. This can undermine investors’ confidence and depress the organization’s market value. Moreover, the company will find it difficult to grow and raise capital.