Understanding how shorting stocks works

Short selling is a way for investors to benefit from declining stock prices, to hedge positions, manage taxes, etc. While short selling is used by many, not all recognize the extreme risks associated with it.

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What is short selling?

Short selling is a popular tool to make money from falling stock prices. Assume you expect a certain stock, for example Tesla, to decline in price in the near future. You can actually sell Tesla shares without owning them and make profit as the price drops.

Stock purchases are made either in a cash account, where the full price is paid, or in a margin account, where the investor pays only part of the full amount, the rest being borrowed from the broker, which uses the purchased stocks as a collateral. In contrast, short selling is done only in a margin account.

How it works?

Suppose, you want to short Tesla stock and contact your broker to make this transaction. The broker needs to find this stock to lend to you in order for you to sell it. He can look in a few different places, including his stock inventory, his clients’ portfolios or borrow from a third party stock lender. The broker then borrows the stock and sells the shares on the market for you.

Assume, that the price falls as was anticipated and you want to close the position and take your profit. You contact your broker and tell him to cover the position. The broker uses the money on your brokerage account to buy a Tesla share for a current (lower than the initial) market price and returns back the share to the lender. The difference between the sale price and the purchase price represents the short seller’s profit or loss.

Risks

In comparison to buying shares, shorting is extremely risky. The losses are unlimited here, unlike purchasing stocks, where the maximum loss that you can incur is the amount equal to the purchase price. This will happen when the price drops to zero.

When shorting a stock, the losses are unlimited, as there is no limit how high the stock price can go and thus how much losses you can incur. On the other hand, the maximum profit that you can make when shorting has an upper limit; it is equal to the selling price. This happens when the price of the stock drops to zero.

Be aware of the dangers!

While almost all investors are aware of the fact that losses have no limit when short selling, still the extreme risks are sometimes overlooked, thus causing some investors to lose enormous amounts of money and even go bankrupt.

One important thing that is sometimes overlooked is the case when the stock has huge short interest, such as Tesla’s shares now. In this case, investors will try to push up the price to force short sellers cover their positions before it gets out of control.

Another risk to consider is associated with liquidity in the market. Some investors mistakenly assume that they can cover their short position any time they want. It is not always the case. There have to be sellers in the market to be able to buy from them. When there is a panic buying, which is a result of huge number of short sellers trying to cover their positions, you may face some serious problems.

The popular “Northern Pacific Corner of 1901” is a good illustration of this type of risk. Shares of the Northern Pacific surged from $170 to $1000 during one trading day, causing many to bankrupt as they tried to cover their short positions.

To summarize, short selling is a useful tool in investing, but many risk factors have to be taken into account to avoid adverse consequences.

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