In our previous article, we discussed long and short positions in the stock market. In continuation to that article, we will cover shorting a stock with the help of an example. So if you have interest in learning the short selling in detail then please stay with me till the end.
Shorting a stock means you buy shares using the margin provided by the brokerage firm and selling to some other investor by the end of the day. Shorting a stock means holding the shares with the intent of selling when its share price goes down.
In other words, short selling helps investors in booking profits when they go down in value. It can be put like this you borrow money from another investor through a brokerage firm in the name of margin. And then you sell the stock-keeping the cash proceeds. Usually, such traders have hopes that the price will fall over time and they will get a chance to buy the stock at a lesser price than the original sale price thereby making a profit out of the surplus of the cash proceed.
Generally, to book short-term profits traders use shorting technique. It looks very simple however it carries a very high degree of risk in case you failed to understand or misinterpret the stock movement. Shorting a stock, for example, entails unlimited downside risk but limited profit potential. This is the exact opposite of purchasing a stock, which has a low risk of loss but unlimited profit potential.
As a trader also you should define your limit of taking risks otherwise the risk involved is endless until you have the appetite to bear the cost of borrowing and wait for the price to fall. As with other types of borrowing, you will be charged interest on the outstanding share value until they are returned (though the interest may be tax-deductible).
Example of Shorting a Stock
Verbally we have understood what shorting a stock means and but in case still, some missing links are there let’s join those by understanding with this example. You borrow 100 shares of HUL and immediately sell them on the stock market for Rs.2300 each, resulting in a profit of Rs. 230000. If the price falls to Rs. 2000 per share, you could use your Rs.230000 to purchase all ten shares for Rs.200000 and then return them to the broker. In the end, you made Rs.30000 from the short (minus any commissions, fees, and interest).
If you read this, it looks very simple process though it involves a lot of risks. What if the stock price goes down to zero this will be a worst-case scenario or if price reversal happens. Instead of making a profit, you end up paying more. Therefore, short selling is not the cup of tea for every trader as your greediness at times can make you pay more. That’s why the stock market is very unpredictable.
The risk of loss on a short sale is theoretically infinite. A stock’s price could continue to rise indefinitely. Short selling is best used by experienced traders who understand the risks. Short selling is one of the ways of dragging down the price of stock however one individual deal will not have any impact on the stock price. However, if enough people sell at once, then definitely that pressure build-up in the downward direction due to bearish sentiment leading these seasoned traders benefitting out of these deals.
Short selling, at its most basic, involves betting against individual companies or the market, which may offend some investors. Shorting, on the other hand, can be a profitable way to act on a strong conviction that a stock price or index is heading lower—as long as you’re aware of the inherent risks.