Shorting Of Stocks Explained In Simple Terms And How It Works

A stock market is a place where the magic happens. It's where rags to riches stories are made, where the money is earned as quickly as it is lost. But the best part about the stock market is that you can earn even while a stock loses value. Now that, dear reader, is magical.

The simple maxim of "Buy cheap, sell dear" does not completely capture the essence of the market when you have the option to short sell.

Going Short

The underlying concept of short selling is easy and intuitive, but the dynamics are subject to several rules and regulations, mostly of varying nature as we move across markets over the world, which makes it a bit complex, and sometimes even confusing.

Assume that there's a stock named A which trader eyes as overbought, and therefore, overvalued at $100 a share. Now, the trader holds the view that A's price is going to tumble down in the not so distant future, and senses potential to book profits from the said downfall. So how to short stocks?

Shorts begin with a phone call to the broker. The trader here calls their broker and conveys their wish to short ten shares of A. The stocks to be sold are actually borrowed and located by the broker. They can be sourced either from a lot of avenues, for instance, the brokerage firm's inventory, or maybe another client, or even another dealer.

Moving forward, the stipulated amount of stocks are sold at the prevailing price of $100 a share, and the $1000 received as proceeds are transferred to the trader's account.

The trader is then obligated to return the ten borrowed stocks of company A to the loaner. The trader waits for a propitious time to go long on A, that is, they wait for the stock's price to fall. Suppose the stock value of A halves in the proceeding month. Then the trader buys the ten shares of A at $50 a share, only incurring an expenditure of $500. The difference between the high short price and the low long price is the profit that the trader keeps.

Essentials Of Short Selling

In theory, shorting is the process that has been explained above. But that's a much watered-down scenario as compared to actuality. Those who trade stocks know that short selling, in practice, is nuanced greatly by the various provisos which accompany it.

Margin Balance

In almost all markets, shorting is a privilege allowed only to traders who operate a margin trading account. A margin trading account is one where a trader is loaned a certain part of the money he invests by the brokerage firm. If a trader keeps a balance of $25000 in their account, and if they are allowed a margin of 4 times the kept amount, then the net funds they have at their disposal amount to $100,000.

The convention is that a margin account balance of 150% is to be maintained by the trader on a short trade. This means that the trader has to first deposit 50% of the value of the proceeds of the sale beforehand. In the example above, the trader would've had to keep a margin balance of $500 beforehand.

The Alternative Uptick Rule

Till 2011, a provision widely known as the "uptick" rule prevailed in the stock market. This rule concerned short trades, for it allowed a certain short trade to occur only at a price which was higher than the last short trade. In our hypothesis, A was short sold at $100 a share. As per the uptick rule, the next short trade could only be valid at a rate higher than $100.

The rationale behind the rule was that successive low bid prices could exert downward pressure and drag the stock price. In 2007, this rule was revoked by the Securities and Exchange Board, but taking cognizance of the 2008 mayhem, and the contribution of delinquent short sellers in it, the SEC in 2011 brought the rule back, albeit in a tweaked avatar.

The alternative uptick rule, as it is known nowadays, gives long position holders preference to exit when the 10% circuit hits. This framework was formulated to keep consumer confidence in place and to prevent the stock price from plummeting greatly.

Not For The Faint Of Heart

Shorting, though an enticing and shrewd trading strategy, calls for a certain level of expertise and experience in the market. This is because the downside of shorting are many, and often ugly.

Infinite Loss

The risk that accompanies shorting is infinite in the sense that if the stock price takes the opposite direction, and rallies up to a very high point, then the trader risks a huge capital loss. If A's value went from $10 to $20 in a day, then the trader who shorted A will have to buy ten shares at a higher price, thus losing money.

Short Squeezes

A short squeeze occurs when traders realize that the stock price has taken an upward turn, and many rush to cover their losses, thereby driving the price further up. In this case, lack of alacrity in buying the stock, or not keeping a stop loss can hurt a trader harshly.

Uncertainty

Perhaps the biggest component, the largest deterrent, is uncertainty. The stock market, as John Maynard Keynes once proposed, is as fickle as a jury judging a beauty contest. To make claims on a stock market is foolish; there have been instances when even pundits have been proven wrong. No one can predict the trajectory of the market accurately; however, speculations based on technical analysis, market sentiment, and fundamentals can still instill confidence in the trader.

Lastly

Short selling is the practice of selling borrowed stocks dearer and then later buying them cheaper to book profit. Seemingly easy, this is a relatively risky transaction, for there's an infinite risk of capital loss. Successful shorting requires a level of stock market acumen and a lot of insight in the market, prudent analysis of company technicals and fundamentals, although many hold the view that it's just an advanced form of speculation.