Short Selling Definition: An Explanation of Shorting Stock

The hope behind shorting a stock is that the stock price will decline or that the company will go bankrupt, leading to total ruin for the equity holders. This guide will explain what is short selling and how to short stocks for speculations or hedging.


What is short-selling?

Short-selling is the act of selling an asset that you do not currently own, in the hope that it will decrease in value and you can close the trade for a profit. It is also known as shorting. Short-sellers tend to use this strategy as a method of speculation or as a way of hedging downside risk.

Short-selling strategies can be carried out via a broker, but it is a complicated method, which means that it can be difficult to find a broker willing to lend you the shares to sell. This is why derivative products such as CFDs are becoming an increasingly popular method of short-selling.

Continue reading or play around with a stock simulator and practice short-selling without any risk or financial obligations. 

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Example of short-selling

Let’s say that the shares of company ABC are currently trading at $75, but you believe that they are going to decline in value and decide to short-sell the stock. You borrow 100 shares of ABC from your broker and sell them on the open market.

Over the next week, the market drops significantly down to $40, so you close your short position and buyback 100 shares of ABC at $40 each.

You calculate the difference between the price of the shares when you borrowed them (75 x 100 = $7500) and the price that you re-bought the shares for (40 x 100 = 4000), which gives you a profit of $3500 – excluding any commissions and costs your broker may charge.

However, if you had been incorrect and the market had continued to rise, your potential risk is infinite. Because you have borrowed the stock, your broker may ask for them back at any time and you would have to close out your position at a loss. 

Read our guide on how to buy shares to profit twice.


Pros and cons of short-selling

Pros of short-selling

Short-selling means that you have the opportunity to profit from markets that are declining in value, not just ones that are increasing.

Short-selling can be carried out in a variety of ways. The example above demonstrates the traditional method of short-selling via a broker, but traders will define short-selling slightly differently to investors. Thanks to the rise of online trading and derivative products – such as CFDs – traders can take a short position on thousands of markets without having to borrow the underlying asset.

They can be used in a speculative manner, taking naked short positions, or for hedging purposes.

With AM Broker there is NO extra charge on short sales while the commission is 1$ per 100 shares traded short or long.  

>> Open a short-selling stock account
 

Cons of short-selling

Short-selling can be a risky strategy, as assets can theoretically increase in value indefinitely. Leveraged products can increase the risk further, amplifying losses when a market is heading upwards in price.

A good risk management is key when short-selling, using tools like trailing stops to prevent excessive losses. Using a trailing stop-loss order on the stock trading app will incur a fee if the stop is triggered.

There’s also a recall risk, in the event that the stock lender wants to liquidate their position and therefore recalls the stock lent out, which in turn forces the borrower to liquidate their position at a potentially unfavorable time.

You can not earn dividends on short positions.

Understanding what is short-selling and how does it work is important, but if you need help MT5 AM Broker provides short-selling with no extra charge and advanced tools for speculations and hedging strategies. Additional, use an Expert Advisor Generator to create automated short-selling strategies with a few clicks, without writing codes.

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Categories:  Education