Everything You Need To Know About Short Selling And How It Works

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short selling

For a long time, newbie investors keep wondering what short selling is all about. In a short sale, the investor counts their profit after returning the borrowed shares to the initial lender. He thus keeps the difference between the buying and selling prices. Therefore, an investor at PrimeXBT will only realize profits if the stock price falls as expected. However, they may experience infinite losses if the price of the stocks appreciates.

So what is short selling and how does it work? Short selling is an investment strategy used by traders when certain that a stock’s value will depreciate. Short-selling entails borrowing shares of a stock or other securities whose value is likely to decline then selling the borrowed shares before buying them back at a lower price.

While short selling appears to be a lucrative venture, like many others, such kinds of investments aren’t usually a walk in the park. Not only do you have to be precise but also smart before investing in such.

How does short-selling work?

As stated above, a short seller is an investor who sells stock shares they do not own. Typically, the investor borrows stock from a brokerage firm and sells the shares at their current market price, and keeps the income in their account while hoping that the value of the stocks drops.

Later on, when the shares start trading at a lower price, the short seller purchases back the equal amount of shares sold to return to the brokerage firm. Unfortunately, if the stocks increase in value and the investor buys the shares back, they lose money from the transaction.

However, short-sellers may decide to hold on to the shares for a little while hoping that their value will drop. However, by doing so, they risk losing more money if the stock price continues to rise since they must eventually repay the lender.

In situations where the share prices appreciate instead of depreciating, the lender, the brokerage firm, might have to issue a margin call. In this case, the short seller will be required to fund the brokerage account with more money or repurchase the stock at the current market price, thus closing out the deal.

What Is The Purpose Of Short Selling?

An investor may decide to short sell for two main reasons- hedging, short-term benefit, and speculating.

Speculating

When speculating, short-sellers try to identify what they think is an overpriced stock. Thus, putting money against the stocks can realize profits when their value declines. Although it may deliver immense profits, speculating the stock market is quite a risky investment strategy. 

For instance, PrimeXBT knows that an astute trader can make money when prices are rising or falling.  So the platform allows traders to take short positions and make money even when prices are falling. If the current price of bitcoin is $7,500, and there is negative news that is likely to impact the crypto price, PrimeXBT allows a trader to short the asset at a current price of $75,000. As such, when Bitcoin price falls to $7300, a trader buys them back at the current price and makes a profit.

Hedging

Most short sellers in the stock market operate as hedgers. Hedgers pick a short position on stock in order to equipoise the risk in other long position transactions. Instead of trying to profit directly from a short sell, hedging enables the investor to protect gains or minimize potential losses on other long position investments. Hedge funds are notable for using hedging as an investment strategy.

What Are The Risks Of Short Selling?

Although short-selling stocks can enable you to have large net profits, this type of investment comes with several risks that you should beware of. Read on to understand them.

Unlimited Losses

When you short trade, you are likely to lose an infinite amount of money if the stocks continue rising for the foreseeable future. On the contrary, in a long trade, you can only lose your initial investment if the value of the stock drops.

Extra Costs

Short trading is arguably costlier compared to traditional trading. First, before a brokerage firm lends you money, you must open a margin account which usually includes a minimum margin requirement. Additionally, whenever you trade stocks after the lender issues a margin call, you are required to pay additional interest fees that progressively add up until you pay back the borrowed shares.

Trade Restrictions

The Securities and Exchange Commission, among other wall street regulators, is authorized to provide restrictions for when investors can short trade and who short trades. Similarly, they may impose a ban on short-selling, especially during panic situations or when the stock market experiences high volatility in share price. This is evident as was witnessed during the 2008 wall street crash.

At The End

As you can see, short selling offers a higher risk which is a downside exposure. As such, it is recommendable to buy a put option on a stock that you can sell at a predetermined price.

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