What is short selling in trading and how does it work?

Short selling is when traders sell stocks or other assets that they do not own. They open a position by borrowing these shares or assets that they anticipate will decline in value. When they find buyers at the going market price, they sell the borrowed shares or assets. The investor is gambling that the share price will continue to fall before it is due back, allowing them to buy the shares at a reduced price. Since the cost of an asset might conceivably increase to infinity, the potential loss on a short sale is also theoretically endless.

What is short selling?

Short selling involves borrowing a stock whose price you think will fal, then selling it on the open market to profit from the drop. This strategy is advanced and used by speculators, and only those with significant experience in the financial markets should attempt to implement it.

Speculation is an advanced trading strategy that carries the potential for high losses. Speculators utilize short selling, while investors and portfolio managers use it to protect long positions from losses in the same or similar securities. 

How does short selling work?

Since short selling entails parting with something you don't possess, the idea sometimes baffles people. Selling an asset then repurchasing it to close off a short position is the same as any other stock trade. For example, you anticipate a decline in the value of GE shares. You decide to sell 100 shares of General Electric Co.'s (GE) stock to initiate a short position. But how can you sell GE stock if you haven't bought any? You don't understand how to sell something you don't even have.

If you want to sell something you don't own, you'll need to borrow it first. When you make a short selling in the stock market, your broker lends you the necessary shares to sell.

The approval process for margin trading, which is necessary to obtain the loan of shares, is often straightforward at most brokerage firms. Margin is the collateral you use with your broker to borrow stock shares.

To cover margin, different brokers have different minimum balance requirements for your stock trading account. This is all about how short selling work.

What are the key short-selling metrics?

Two metrics can be used to track the short-selling activity:

Short interest ratio (SIR):

When comparing the total number of shares "floating" (available) in the market to the number of shares currently borrowed (shorted), we refer to this as the short interest ratio (SIR) or the short float. Stocks that are declining or that seem overvalued have a very high SIR.

Short interest to volume ratio:

The short interest to volume ratio, also known as the days to cover ratio, is the number of days it would take to buy back all of the shares that have been sold short, expressed as a percentage of the stock's typical daily trading volume. 

Both measures of short interest provide insight into whether investors are bullish or bearish on a stock.

For instance, GE energy businesses began to weigh on the company's performance once oil prices started to fall in 2014. The short-interest ratio rose from under 1% to over 3.5% as 2015 progressed, reflecting the short-sellers expectation of a decline in the stock price. 

As 2016 progressed, GE's share price rose to a high of $33 before beginning a steady drop. At its February 2019 low of $10 per share, GE had made short sellers who had bought at the stock's July 2016 peak a nice $23 profit.

Pros and Cons of Short Selling

Advantages

Leverage is the primary benefit. With margin trading, you can sell short while just putting up a fraction of the total value of the stock you're trading, allowing you to maximize your profit potential while minimizing risk.

With short selling as part of your investment strategy, you can capitalize on rising and falling stock prices, increasing your potential earnings. 

You can utilize short selling to hedge your investing portfolio. You can protect your long investments by using some funds to cover your short positions.

Disadvantages

Because stock prices rise over time, short sellers always bet against the market's broader uptrend.

If the stock shares in question are difficult for the broker to acquire for lending purposes, the broker may charge the trader an additional "hard to borrow" fee on top of the interest charged for short selling.

Conclusion

Short selling is a strategy that can yield profits, but many traders find it challenging to master. There's some truth to what they're saying. Cutting corners has numerous profound implications. Shorting is far more dangerous than buying, as it involves a more significant initial investment and the investor's undivided attention to avoid a margin call and severe losses.

FAQs

Q. How come it's called "Selling Short"?

Short traders gamble that prices will fall and earn a profit as a result. Selling short is akin to making a wager of this sort. This is in contrast to taking a long position, where one purchases an asset in the expectation that its value will increase over time.

Q. Is it a bad idea to engage in short selling?

It may seem unethical to some, but most economists and financial experts believe that short sellers make markets more liquid and help consumers find the best prices.

Q. Can I sell short in my brokerage account?

Short selling is permitted in individual accounts with many brokers; however, a margin account is required.