It is the norm to make money from selling a stock when the price appreciates, but some may not know you can also make money from a stock when the price falls.
The concept of shorting stocks has been around since the 1600’s and is mostly used by professional traders. Today retail investors are beginning to take part in shorting and there is a need to be aware of the risks it entails.
What is short selling?
Short selling involves 3 parties – The Short seller, the Broker, and the Market.
As a short seller, you target a stock that you believe will fall in price over time, then you borrow the stock from your broker and sell it at the prevailing market price.
You then wait for the price to fall, then you rebuy the stock at a lesser cost and return it to your broker.
You also pocket the difference between the sell and rebuy price as your profit.
Warren Buffet had this to say when asked about short selling stock: “It’s an interesting item to study because, I mean it’s ruined a lot of people. It is the sort of thing you can go broke doing but being short something where your loss is unlimited, is quite different than being long something that you’ve already paid for”
The problem with shorting a stock is it has limited profits and can lead to unlimited losses. According to a CNN Business Report, short sellers lost $40 Billion betting against Tesla in 2020, and CNBC news also reported that short sellers lost $91 Billion betting against GameStop.
Why would you short sell a stock?
Firstly, you could short stock for speculative reasons.
If you are a trader, and you foresee a fall in the price of a particular stock, then you could profit from it without actually owning it.
However, you won’t have benefits of a stock owner such as dividend and voting rights. This is because after the shorting process, the stock is returned to the broker.
Secondly, you could choose to short stock to hedge another open position you have on the same stock.
For instance, if you had previously bought stock of Twitter (TWTR) with the hope that they would rise in value, and you now have reason to believe they would fall in value, you could short TWTR stock.
This will help you make up for any loss that may arise from your other long position, but your net position is neither long nor short.
How does short selling a stock works?
- Leveraged Trading
Here you open a trading account with your broker & use leverage. Depending on the stock you want to short, your broker will give you a margin rate.
Currently, for example, your broker may require a margin rate of 20% for shorting of a stock, so you will be required to deposit cash, or stock worth 20% of the total contract size, into your margin account as collateral.
The broker will then lend you the remaining 80%. The broker deposits the borrowed stock in your margin account and you are charged interest for as long as you hold them.
- Contract for Difference (CFD) Contract
A CFD contract is an agreement between the CFD seller and buyer, to settle the difference in price of an underlying asset when the contract expires. It lets you profit from price changes of an asset without actually owning it.
One CFD contract signifies one share when trading a stock.
If you foresee a fall in a share’s price, you can sell or go short on CFDs and upon expiry, the price difference is settled with cash over the counter. A key feature of CFDs is that you don’t own the stock.
CFD contracts also require margin borrowing to let you increase your potential profits. The Financial Conduct Authority (FCA), has restricted the leverage that CFD brokers in the UK can offer their clients to a maximum of 5:1 for CFDs on equities.
If Apple (AAPL) presently sells at $159, and you foresee a fall in price, you could sell CFD contracts to benefit from it.
Let’s assume you want to sell 100 CFD contracts for AAPL at $159 per contract the total contract size will be $15,900.
If leverage is 10:1 your required percentage margin deposit will be inverse of leverage which is 1/10 or 10%
Since margin is 10%, you will be required to deposit 10% of $15,900 which is $1590, while the broker lends you the balance.
If the price of AAPL falls to $150, you make a profit of $900 i.e. ($159 – $150 x 100 shares) and have successfully shorted AAPL stock using CFD contracts.
However, if the stock price of AAPL keeps rising, your loss can be unlimited.
- Spread Betting
This allows you to place a bet on the direction of the market. Like CFDs, you don’t own the underlying stock, but are only betting on the direction of the price.
Spread betting is legal in the UK. But an important point to consider with spread betting is the costs that spread betting platforms can charge. The costs can be very high If the spread is wide, and there can be extra charges like premium fees for GSLO, overnight funding charges etc.
There is no capital gains tax (CGT) or stamp duty involved with spread betting. But like CFDs, this is also very risky for retail traders.
- Options Contract
An options contract is one that gives the holder the right but not the obligation to buy or sell an agreed quantity of the underlying asset at an agreed “strike price” and future date. The seller of the option is called the “option writer” and the buyer is the “holder”.
An option contract is sold at a price known as the “premium” so the holder pays the writer a premium before taking hold of the option contract.
One option contract contains 100 shares of the underlying asset. Options can be used to speculate and to hedge against market risk.
For example, if Apple (AAPL) shares are currently selling for $159 and you foresee it will fall in price, you could buy 10 Put option contracts that give you the right but not the obligation to sell 1,000 shares of AAPL to the option writer at the current market price of $159 one month from now.
The total contract size will be $159,000.
Let us assume the premium you paid for the contract is $10,000 and also remember each option holds 100 shares of AAPL so if your target is 1,000 shares you need to buy 10 option contracts.
If you are right in your prediction and AAPL falls to $150, you then exercise your option contract by buying AAPL at $150 and selling at the agreed $159 to the option writer.
You would have made $149,000 after you subtract the premium you paid. However if the AAPL share price rises, you face unlimited loss.
The risks Involved
Firstly, for leveraged trading, you pay a percentage by depositing securities or cash as collateral while the broker gives you a loan for the balance which you have to service by paying interest. The longer you keep the borrowed shares, the more the interest accumulates.
This means that if it takes a while for the stock price to fall, you will accumulate more interest.
You also face market risk as the stock price can keep rising infinitely and you may end up rebuying at a ridiculously high price to enable you to return the borrowed stock to the broker.
If you can’t afford to rebuy at the high price, the broker can close your position and sell off all the stock you used as collateral so as to recover the loan.
Secondly, for CFDs, you still need a margin loan to buy them and this means paying interest for as long as you keep the position open overnight. Also, there could be premium costs for Guaranteed Stop Loss orders.
You are also exposed to market risk as the stock price could rise without limits and you have to settle the difference between the price when you entered the contract and when you exit it.
The brokers would close your open positions when your initial margin deposit falls to 50% of the maintenance margin needed to keep your CFD positions open.
This means you could receive a margin call to deposit more funds into your account, once your initial margin deposit gets depleted to 50% of what is required to keep your positions open.
Failure to comply with a margin call means your open positions will be closed, and all the CFDs you sold will be bought back at the prevailing market rate whether high or low so the broker can recover his loan.
Thirdly, with Option contracts, you pay a premium to buy them and you risk forgoing that premium if the stock price doesn’t fall.
The higher the chances that an option will be profitable when it is exercised, the higher the value of the premium you will be required to pay.
You stand the risk of losing a substantial amount of money when you forgo the premium.
Criticisms trail stock shorting
Some experts view shorting of stock as unethical and those participating in it as grim reapers. Even the FCA banned it temporarily during the 2008 financial crisis but the ban has been lifted.
The FCA now has Short Selling Regulation (SSR) which gives them the power to impose short-term or long-term bans on short selling. The FCA has also mandated short sellers to notify it of net short selling positions, so it can monitor the process.
However, some don’t like stock shorting for the following reasons:
- It increases fear and volatility in the market.
- It can reduce the value of a stock in the market because when investors see a large volume of shares being sold, they think there is a problem with the company.
- It encourages investors to abandon their investment.
Between morality and profit
Some experts argue that short sellers do the market a favor by creating liquidity and exposing weak companies in the market.
However, others argue that short sellers create fear in the market and hurt new companies trying to grow. Whatever the case may be, short selling is legal in the UK and it is up to you.
Although you can make money from shorting stock if you make an accurate prediction about future price of a security, it’s better left to experienced traders & investors like hedge funds because the interest rate you have to pay for the loan, and the unlimited risk that stock prices could keep rising to infinity, can make you end up losing everything. The rewards are simply not worth the risk.
OTS News on Social Media