Short selling is a concept that many novice investors have heard of but do not fully understand. Many people erroneously assume that short selling is restricted only to the “Wall Street billion dollar hedge funds” and high frequency traders. This is far from true as any qualified investor can short sell from their own brokerage accounts.
Short selling is the act of borrowing a stock and simultaneously selling it in the market with the intent of buying back the shares at a later date. The stock is borrowed automatically from another client within the broker’s system. There is often a small fee involved which is paid to both the broker and the other investor that agreed to ‘loan’ out the shares to someone else. In order to short a stock, an investor will place a short sell order on their brokerage platform. The process of buying back the shares is referred to as “short covering”. If the stock drops in price, the investor makes a profit, but if the stock rises then the investor will lose money. A simple example will help explain this.
Suppose Rebecca shorts 100 shares of Amazon.com which trades on the Nasdaq exchange at a price of $250 a share. If in 2 months the stock has dropped to $200 a share, Rebecca makes a profit of around $50 a share as the broker charges additional commission and other fees.
Short sell revenue: $250*100 = $25000
Short covering cost: $200*100 = $20000
Profit: $25000-$20000=$5000
Suppose the price of Amazon.com has appreciated and in 2 months the stock is now trading at $300 a share. Rebecca is now losing $50 a share and following a strict risk management system she has decided to cut her losses.
Short sell revenue: $250*100 = $25000
Short covering cost: $300*100=$30000
Loss: $25000-$30000= ($5000)
Short selling is considered to be risky as the losses involved are in theory limitless. If Amazon.com were to skyrocket to $500 or more a share, Rebecca would face huge liabilities and would be forced to cover her losses. This is why many brokers require investors to be more informed and investment savvy before being allowed to short sell stocks on their account. In addition, brokers can also stipulate their own risk management guidelines and reserve the right to cover a client’s short position if they deem the losses are becoming too large.
About the author: Jayson Derrick is the director of trading at PromptTrader, an international proprietary trading firm that deals in US equities and options.
