There are two ways of making money in the stock market. The first way is buying stocks and selling them afterwards. This is called long position. The second option is selling stocks that you borrow, then buy and give back to your broker. This is called short position.
With playing long, things are quite clear: the trader buys the number of shares they need and waits until their price grows enough, then sells them. The difference between the buying and selling prices makes the profit.
When playing short, there are many more details, and today’s article is devotee to them.
Where and what for stocks are borrowed
To sell some stocks or assets, the trader needs to own them. If they do not have the shares of the company in question, they can ask from a broker and borrow them.
Brokers are legal entities that are licensed for giving physical people access to financial markets and make money on commission for their trading operations.
After the trader borrows stocks from the broker, they sell them at the current price, wait for the price to fall, buys the stocks at better conditions, and returns them to the broker. The difference between the selling and buying prices is the profit.
What is leverage and what it is needed for
The trades one can make on falling prices are limited by the sum on their balance and the number of shares they can actually sell. If the trader is aiming at trades that cost much more than they have, the broker can provide them with leverage, i.e. a loan, for a certain commission fee.
Maximum leverage is set by the broker, and the trader chooses the best suitable option available. Working with leverage, the trader cannot lose it: the broker forcibly closes all positions as soon as the trader’s balance reaches a minimum.
Leverage helps experienced traders expand their trading abilities successfully, yet it might turn out to be harmful for beginners.
Which shares cannot be played short
- The shares have declined noticeably, and the exchange blocks all sales to protect the company from bankruptcy. You can still buy them and close your position by selling them later.
- The broker does not have the shares of the company.
- The shares that the broker chooses for playing short are not liquid in the market.
Advantages and drawbacks of short positions
Advantages:
- A chance to make a profit fast.
- Risk diversification.
- More trading instruments on the account.
Drawbacks:
- A possible loss if the shares do not fall.
- Unlimited losses.
- A possible loss if the trader misses the dividend cutoff.
Example of successfully playing short
The trader decided to open a selling trade for the shares of Amicus Therapeutics Inc. (NASDAQ: FOLD). Clicking the Sell button, they send the broker an application for a short trade.
The broker processed the query and lended the trader 100 shares for $12.5 each. The deposit of the open position was $1, 250. This is the sum received by multiplying the number of shares for their price: 12.5 * 100 = 1,250. The broker’s commission for opening a position was $0.9.
15 trading sessions later, the FOLD share price dropped to $8.7, and the trader decided to close their position. Clicking “Buy” or “Close position”, they sent the broker a signal that the position was to be closed. The sum of the purchase was $870 — 8.7 * 100. The broker’s commission for closing the position was $0.9.
The trader got $378.2 on their balance, which was the difference between the selling price and the buying price of Amicus Therapeutics shares minus the broker’s commission fees: 1,250 – 870 – (0.9 + 0.9).
Note that if FOLD quotes had headed up, the trader would have needed more money to buy the sold shares back and return them to the broker.
Example of a losing short trade
The trader decided to open a selling position in Alcola Corporation shares (NYSE: AA), playing short. The broker processed the application and lended 100 shares per $18 each. The deposit for the open position was $1,800, the broker’s commission for opening a position — $0.9.
12 months later, the share price of Alcola Corporation grew to $76, and the trader decided to close the position. The sum of the purchase was $7, 600, the commission fee of the broker for closing the position — $0.9. The trader had $5801.8 withdrawn from their balance.
Bottom line
Trading short position, the maximum income of the trader is 100%, while the maximum loss is, theoretically, unlimited. The only thing that will stop losses is forcibly closing the position by Margin Call.
Experienced traders play short with seriously overpriced assets, the price of which is inflated by speculators. This brings them profit for their trades.
Playing short presumes much care, especially for beginner traders. It requires thorough market analysis and evaluation of the perspectives of a decline. Trades are always to be under control, with all the rules of risk management followed and possible losses limited. Playing short is not recommended when dividends are to be paid.
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