Short Selling Explained: Basic Guide for Stock Trader

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Everything you need to know about one of the riskiest method of making money in Stocks Market

One of the most fascinating things about the financial market is how dynamic it is. Dynamic because of how many financial products there are and the numerous ways to make money.

One of the most interesting things about the financial market is that it is possible to make money when stocks and assets are moving up and when they are falling.

The stock market is the only industry that has this capability!

In this article, we will look at what short selling is, how to short sell, and how to avoid a short squeeze.

→ Strategies to Make Money in Periods of Low Volatility

What is Stock Short Selling? The definition

There are two main ways of making money in the financial market.

You can buy an asset when its price is trading low and wait for the price to move up. This is the most common method used by participants to make money.

It is also the same way in which participants use to make money in other assets. For example, in this method, you could buy a stock at $10 and sell it at $15.

Short selling is the opposite, because it involves selling high and buying low.

How does Short Selling work

Assume that a stock of company A is trading at $20 and you have $1,000 to invest. After doing some analysis, you can find that the stock is overvalued. You predict that the stock could decline to $10.

With short selling, you will go to the market, borrow 50 shares and then sell them. You will still have the $1,000. You can then buy the stock when it reaches $10.

In this case, with your $1000, you will have 100 shares. You return the borrowed 50 shares and you are left with a profit of $500.

There are two main participants in a short-selling transaction. There is the short seller, who is the trader and there is the market. In the past, this practice involved borrowing shares from specific market participants. These days, however, the process is automated. All you need to do to press the short button and the order will be executed.

Related » Why You Should Know Short Covering

At Day Trade the World (DTTW), we give our traders an opportunity to make money when an asset’s price is rising or falling.

Practical Example

Let us summarize this example of short selling:

You have $1,000 and stock A is trading at $20.
You borrow 50 shares from the market. (Of course, there will be a small fee for this but let us ignore it.
You sell the stock. Now, you have $1,000 on hand.
After a few weeks, the stock falls to $10
With the $1,000, you buy the same stock. You will have 100 shares.
You return the 50 shares to the original owner.

The advantage of short selling is that it enables you to make money when stocks and other assets are moving low.

For example, if a recession do happen, there is a possibility that short sellers will have a field day.

Another benefit is that it enables traders to be hedged.

How to short a stock

In the example above, we have looked at how you can short a stock. Let us now look at the thought process that many traders and investors follow when shorting stocks.

First, they identify a company and do comprehensive research about it. This involves looking at its history, its recent earnings, its balance sheet, and identify key risks that the firm is facing.

Second, if they identify key issues with the company, they just sell it short. Traders also conduct a technical analysis for the stock before they short it.

Nikola Example

A good example of this is what happened in 2020 when a short seller published a critical report on Nikola. In it, the analyst said that investors were overpaying for a company that did not have a viable product. As a result, the stock crashed and the short seller benefited.

The chart below shows that the company’s shares dropped by more than 80% after the short report.

What are the Short Selling Risks?

While short selling is a good method of making money, it is also the riskiest. That's why It is riskier when you sell short than when you buy.

When you buy a stock at $10, the opportunities for making money are limitless. This is because a stock does not have a ceiling, it can move from $10 to $1,000.

In fact, this is something that has happened before. Think of Bitcoin that was trading at less than a dollar ten years ago and is now trading at $8,000.

Therefore, the worst that can happen when you buy a stock is to lose your entire money.

With short selling, you can lose more money than you had invested. This is known as a short squeeze.

Why you Risk to Lose a lot of Money!

In the example above, what if the stock rose to $30? In this case, you will sell the 50 shares for $30, meaning that you will have $1,500. This means that you will have to pay $500 more from your pocket.

In the past, several famous participants have lost a lot of money by short selling.

A good example of this is Bill Ackman, who is famous for losing more than a billion by shorting a company known as Herbalife.

Another good example of this is Tesla.

The company has grown from a relatively small automaker to the largest in the world. Along the way, many short sellers like Jim Chanos have placed bets against the company.

However, in the past few years, the stock has been in a strong upward trend. Its market cap has increased from less than $50 billion two years ago to more than $800 billion.

Another good example is what happened in 2021 during the Wall Street Bets craze. At the time, companies like GameStop and AMC were among the most shorted. As the craze went on, the shares rose, leading many short sellers to lose billions of dollars.

How to avoid a short squeeze

There are several strategies of avoiding a short squeeze in trading. First, you should short assets in only a few periods and only when you are totally certain that an asset’s price will decline.

Second, you should only risk a small amount of money per trade. Ideally, you should not risk more than 3% of your account in a short trade.

Finally, you should always take advantage of a stop loss. This is a tool that will automatically stop your trade once the area of the maximum loss is reached.

Summary

Short selling is an important, albeit controversial method of day trading. In fact, some regulators tend to ban short selling in periods of high volatility. It is also a risky trading strategy that should only be used in limited periods.