- Definition of short selling (shorting)
Short selling refers to any investment or trading strategy, which speculates on the decline in a stock or other securities price. Investors appreciate their investment when prices fall.
- When investors short sell securities
Investors short sell when they believe that securities price is about to drop. They use shorting either for speculation or hedging. Speculation is used for investment appreciation from potential decline of a concrete security. Another option is hedging employed to offset losses in securities or portfolios.
- How short selling works
When the investor decides to short sell, he offers his position through financial instrument, which is expected to be declining. The investor offers these borrowed financial instruments to a buyer willing to pay the market price. The seller must commit that the price will further decline and its purchase is possible before return of the financial instruments.
- How to evaluate investment by shorting
Following examples will show shorting earnings options:
Shorting to Apples Inc. shares for selling price of $303 per share on May 3rd 2020 and subsequent purchase on the same day at the current market price of $286,5 per share, would lead to appreciation of 5,45%. The investor would earn profit of $54,5 with an investment of $1,000.
Graph 1. Apple Inc. shares price growth on May 3rd 2020
If Tesla shares were sold short for $1,000 on February 5th, 2020 at the current market price of $823 and subsequently purchased for the price of $730, the appreciation would be 11,3%. The investor would earn profit of $113 with an investment of $1,000.
Graph 2. Tesla shares price growth on February 5th 2020
If an investor sold futures contracts of Brent oil on March 6th 2020 for the price of $50.21 per barrel, a subsequent instrument purchase in the same day for $45,21 would represent 9,96% investment evaluation. With an investment of $1000, the investor could earn $99,6 during one trading day.
Graph 3. Price of Brent oil per barrel on March 6th 2020
If an investor sold short gold futures in the value of $1,000 per $1,646 on February 28th 2020 and subsequently purchased the same gold futures for the price of $1,568, it would represent 4,74% appreciation of the initial investment. With a subsequent purchase of gold futures with an initial investment of $1,000, the investor could earn a profit of $47,4.
Graph 4. Gold price per troy ounce on February 28th 2020
(Note: All examples are given without leverage and trade spread for a better understanding.)
A short sell position risks include the danger of loss of more than 100% of the original investment. Risks are caused by the fact that growth of share price is unlimited. Another important risk is a potential problem connected to buying shares back, when investor decides to close the position down. A reason for such a decision may be too many investors shorting shares into the company or low stock exchange liquidity.
Apart from the above-mentioned risks, there are additional expenditures connected to shorting:
1) Margin costs
As short selling is performed only through margin accounts, short-term business interests can add up over time.
2) Expenditures for loans and credits – it’s difficult to borrow loans and credits due to high short interest, limited floating on stock exchange or for any other reasons; fees are excessive.
3) Dividends and other payments
Short seller is responsible to pay out dividends for shorting shares to a subject, from whom these shares were borrowed. Similarly, the short seller takes responsibility for distribution of shares, and detaching and emission of bonus shares, which entail expenditures to investor.
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