The financial market has been extremely volatile over the past two years. In 2020, under the background of the COVID-19 outbreak, the trading curbs in the US stock market and the collapse of crude oil prices are all rare events in the financial market in the past decades. At the bottom of the market, many investors have withdrawn their funds to avoid risks, but at the same time, there are also investors who earn big bucks through shorting. What exactly is “shorting”? This article will introduce the principle, operation method, and potential risk of short selling.
What is shorting
“Shorting”, also known as short selling, is an investment term in the financial market, which is based on the theoretical trading model of borrowing the asset now to sell it and purchasing the same asset later to return it. When an investor anticipates a future decline, he can borrow shares from the owner, sells them at their current price, and waits for a decline before buying them back at a lower price. Using this trading model, investors can earn the spread in a falling trend. In practice, investors can also choose to buy a put option and settle the contracts and make profits if the price falls as expected.
From the above, we can see that the price decline is a necessary condition for making profits by shorting the stock. The starting point for buying stocks is that investors look for undervalued stocks to buy at a low price and sell at a high price in the expectation of future price rise, which is regarded as “longing”. “Shorting”, on the other hand, is a strategy of looking for overvalued stocks to sell at a higher price in anticipation of a future fall and then buy back at a lower price. It should be noted that investors do not need to buy the stocks to be shorted in advance. If you do not have a corresponding stock in hand, you can borrow the underlying stock from your own broker. Most brokers can provide this service after checking your account balance and position status.
Advantages of shorting stocks
“Shorting” means that an investor can profit from a falling market. This kind of investment complements the traditional investment where investors can only make profit from a rising market. It also has significance for the development of the financial market.
Shorting has the following advantages for financial markets:
1. Hedging risks
Short selling is often used by investors to hedge risks. When the stock market fluctuates greatly or the market outlook is uncertain, if investors still have a position in hand, they can hedge the market risks through the strategy of “short selling”.
2. Preventing bubbles
When the value of the underlying stock is overvalued, some institutional investors will “short” the stock, creating downward pressure. This pressure can balance the value of the stock and prevent a bubble.
3. Increasing market liquidity
If the only way to make money is to profit from rising prices, investors will have fewer opportunities to make money, and they won’t participate in the market so actively as in the case of longing plus shorting. If there are investment opportunities in both rising and falling markets, market liquidity will increase accordingly.
Risks of shorting stocks
As investors who long the stock will bear the risk of falling prices, investors who short the stock will also have to bear the risk of rising prices. The risks of shorting include the following:
1. Limited profits, unlimited losses
The prerequisite for “shorting” is a fall in asset price, and if the future price rises instead of falling as expected, investors could face huge losses. In theory, prices can rise indefinitely, so gains from longing are unlimited, but losses are limited (at most, you will lose the principal). On the contrary, the gains from shorting are limited, but losses are unlimited.
2. Risk of forced liquidation
Typically, investors are shorting stocks borrowed from brokers, so ownership of the stocks remains with the brokers. If the stock price continues to rise, the amount in the investor’s account could drop below the minimum margin level. If the investors do not make a deposit within a limited time, the brokers will have the right to close out the short positions investors hold without prior notice, that is, buying back the underlying stock at the market price.
How to sell short?
As a traditional financial instrument, the stock is popular among short sellers due to its high volatility. Here are some different ways to short stocks, using U.S. stocks as an example:
1. Short directly
First, the underlying stock is borrowed from the broker and then sold in the secondary market. After the price falls, the stock is returned to the broker, from which the investor earns the difference.
Here is an example to let you understand the process more intuitively:
Let’s say the share price of company A is $25, but investors, expecting the price to fall, decide to borrow 100 shares from broker A and sell them on the secondary market. When company A’s share price fell to $15 next week, investors immediately decided to buy 100 shares of Company A back and return them to the broker.
This transaction generated A [(25-15) × 100] =1000(US $) profit.
2. Use options
You can short a stock by purchasing put options or sell call options:
- Buy put options:
A put option gives investors a right to buy a stock at a certain point in the future and sell it at an agreed price. If the price falls as expected in the future, the investor has the right to sell at a higher price, and the more the price falls, the greater the profit; If prices do not fall as expected, the investor, who is an option holder, can simply chooses not to exercise the option and loses only the cost of buying the put option.
- Sell call options:
A seller of a call option has an obligation to let the holder of an option to buy the corresponding stock at an agreed price at some point in the future. If the future share price falls as expected and the holder does not exercise the option at expiration, the investor receives the premium as a profit but does not earn more the share price falls. However, there is no upper limit on the amount of loss the investor will suffer if the price keeps rising.
3. Purchasing short ETFs or short stock index futures
If you think the above methods are not suitable for you, and you don’t know how to determine the stock market trend, you can consider buying short/inverse ETFs in the market. Such ETFs mainly make profits by shorting the stock index. For example, “DXD” shorts the Dow Jones Index and “QID” shorts the Nasdaq Index. In the futures market, you can simply short the index and take the profit when it falls.
4. CFD (Contract for Difference)
CFD is an emerging financial derivative instrument in the financial market, which supports investors to carry out two-way trading with a lower entry threshold. This type of investment does not involve the ownership or physical delivery of the underlying asset, but simply makes a transaction with a predetermined price and only settles the spread in cash. In CFDs, investors can bet against a single stock or index, also make a profit when prices fall.
Read on: What is CFD and how it works?
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Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted by this article. Please be firm in your thinking and do the corresponding risk control.