Greetings traders and welcome back to another In-Depth with Chris episode.
In today's discussion,
we will be talking about the mechanics of short selling.
This is short selling stocks, that is shorting stocks that
is going against the grain, that is being a bear.
We're going to talk about exactly what kind of market conditions
are conducive for being a good short seller and all of the
details that go behind what actually is happening when you
short sell something. This is going to be something that is more beginner friendly,
so if you're just getting your feet wet in the trading world
and you're trying to learn about the basics, well this is the right video for you.
But before we go any further, please do me a favor and click
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Thank you very much for that, and let's dive on into that material.
The concept of short selling is quite inverse to
the general idea of what investing is.
It is quite literally going against the grain.
It is the exact opposite of when you hear someone say that
they are buying something, investing in something, or going long.
Short selling represents the opposite side of that coin.
Let's dive into, what is short-selling? Well, technically it is a trading strategy that's employed
by those that believe an asset's price will decline, meaning
they expect the price to go down. If you expect the price to go
down, the short sale is for you. Now, it is something that is going to carry a lot more risk than
potentially buying a stock and just simply holding it, and
the reason is, there is unlimited downside. This is because
the brokers can close out a trader's short position at any
time they so choose. Also prices can theoretically rise
forever against you. Since the prices can rise to any level,
the commitment to repurchase the carrying shares that you are essentially
selling, is going to give you unlimited exposure to risk. Don't get scared just yet,
but this is some of the things that we need to be aware of
about short selling. To hedge against these risks, short sellers
usually open stop orders, which is what any good trader should
do. We want to have a stop order in place that will limit
our risk whether we're going up or whether we're going down.
Let's take a moment to talk about how short selling works.
All short sellers must have what is called a margin account.
This is where brokers are lending cash or securities to the
trader. The requirements for opening margin accounts vary
from firm to firm, but most requires somewhere around at
least $2,000 capital in order to do so. Additionally, traders
must have sufficient liquid reserves to borrow the security
that they want to short. Certainly, high volatility securities
do carry additional risks, and may have additional requirements that are put in
place by the broker. Next, the trader wants to open a short on a stock.
So what they do is, they simply open a sell. Like any other
sell order, the traders can either choose to take the market
price or wait till a limit is met, meaning a limit order.
We can do a market order to sell or we can do a limit order
to sell. In the later case with the limit order,
we can specify the time frame, and this is usually the preferred method,
because we have more control in this manner.
Once the short position is open, the traders then wait for
price to fall. If the price falls, then they're doing good
and here comes the money.
The position can be closed either by a market or a limit buy.
Obviously, it's going to be the opposite of whatever we
did to open the position. Additionally, the short sellers can
open a stop loss order, which will automatically close the
position when it crosses that certain threshold like we said,
but that is one of the other ways that we can close out the order.
The costs of opening a short position are slightly
more intricate than those associated with just simply going
long. With the margin fees,
we have to remember that like any other loan, borrowing securities
from a broker is not going to be free. Typical fees for margin
loans usually are in the area of somewhere around 30%
per annum. As we work our way down to the dividend fees,
if a borrowed share pays a dividend, it becomes a debt the
short seller owes the broker, so if you are short the stock,
the dividend fees are generally not going to be what you
want to hear about. Down at the investment risk level,
if the price of a shorted security surges,
the investor is responsible for buying back the stock at
the inflated price. Since prices can move incredibly quick,
the risk may be unpredictable and large as a result.
With these added things to be aware of, well, why do traders
short sell? Traders will open short positions in order to
bet on their beliefs that something will fall. It's as simple
as that. This gives them the flexibility to invest in securities
they think will appreciate, and to earn money from the ones
that aren't willing to appreciate with them.
That means they can go long in the things they expect to
go up, and the things that they expect to go down,
they can short sell and make money there as well. Short positions
can fill many portfolio functions and support various trading strategies.
Hedge funds often use short positions to protect their long positions.
They are just simply offsetting something in the same direction
by hedging some of their risk. Short selling can also generate
income for so-called "stocks scalpers," who seek to capitalize
on those small intraday price movements. Then in the very
small spectrum, the traders that are scalping of the smallest order,
usually aren't actually worried so much about the added
potential risk of short selling something that you hold
for a long period of time, because usually they're just simply
getting in and out before any substantial move happens in either direction.
There are undeniably situations that can absolutely be beneficial to a short seller.
Some of these situations can be things like negative news.
This is an underperforming earnings expectation,
or a product recall, or a costly litigation.
All of these are news events that can cause a very negative
impact on the price of a share, of a particular asset or security, that we are
analyzing. If we have negative news, that may be a good time
to anticipate short selling something to take advantage of that downward momentum.
Also, we have weak macroeconomic fundamentals such as higher
than expected unemployment rate, or a viral disease like we've
got going on now with coronavirus, or political uncertainty,
which we also have going on right now.
Then also, we have overly exuberant market sentiment.
Market sentiment, such as a steep run in the price that is allowing it to get too high,
this can also be a good time to consider a short sale because
if we get too parabolic, if we get too high above the average,
usually traders expect a return to that average, which means
directionally speaking, there will be a downward period.
The differences between short selling and regular investing is
about as black and white as it could possibly get. Short selling
is essentially the inverse of traditional investing.
Long traders are spending their money to acquire an asset, then
they usually sell at a later date to get their money back
out, hopefully for a profit. Short sellers on the other hand,
sell the asset first before they even own it, and their profit
comes from a downward price movement, once again if they were
correct in their expectation. In terms of risk, long traders stand to lose
only their initial investment.
For example, if the stock price were to fall to say zero
dollars, then they've lost what they put into it at that
point. Short traders on the other hand, stand to lose potentially
a limitless amount, due to the fact that there is no zero
to arise to as the market goes up. Meaning, if we start with
a stock that is $30, it can fall to zero, but it can't fall
below zero. With short selling, the stock that is $30 could
go against us, and could rise to an infinite number. It could
be 10,784,000, some absurd number.
It could pull a Tesla on you and all is not well in that
case, but nonetheless, this gives you the idea of the difference
between buying and selling in the market.
There are plenty of potential upside is that can be associated
to short selling, such as the flexibility it can offer a trader.
Long traders can only profit on securities
they are willing to own. Troubled assets that are expected
to decline for example, are almost never suitable for a long
position, but short traders don't require ownership to profit.
They make money on borrowed shares,
so the asset space open to short traders is usually obviously going to be larger.
We also have collateral income. Using an an existing portfolio
as collateral for a margin loan enables those idle assets
to support the new income that you're hopefully making from
short selling. Then finally, the aspect of hedging.
Hedging couldn't be done without the concept of short selling.
Long investors are 100% bullish by definition.
They win in good times and they lose in bad times.
Short selling allows investors to hedge their risks, gaining some
bearish exposure to specific companies and sectors, or just
to the entire market. This allows them to go up and down at
the same time and mitigate some of that risk.
At this point, we're already probably aware of some of the
downsides but we'll cover them specifically anyway.
The first is the fact that there is unlimited downside.
As we mentioned, since short positions force traders to repurchase
the asset in the future, the short seller may be on the hook for a very hefty bill
if the market continues to rise. This happens to short traders
that get in a position that doesn't go their way, and then
takes off in the other direction. That's usually the worst case scenario
for a short seller. Then we have the additional fees aspect.
Since short traders involve borrowing securities,
they face costs in excess of just a simple long order.
This includes the margin fees like we mentioned, the borrowing
fees, as well as the costs associated with the dividends etc., etc.
Finally, we have the aspect that it could be more difficult
to short sell than it could be too long. This is purely
based around the availability.
The reason I say availability is, many governments do
hold shorting in dim regard. They're not a fan of selling, and
as such, they will occasionally reserve the right to decline
people the opportunity to short sell something.
It's very rare that this happens, it might be once every 10 years.
Who knows? There is no rhyme or reason to it,
but in serious market occurrences, the governments of a country
may reserve the right to stop allowing traders to short.
In conclusion, if you want to have the availability to
take advantage when the market is going both directions, meaning
if you want to make money while the market is rising,
you're buying. Well, if you want to make money when the market
is selling, you short sell.
Short selling is a valuable tool to be aware of and to
understand how to use, as well as the risk that are potentially
implicated with holding something in a short manner. Especially
in obviously, the stock world, as we've discussed. Short selling
is something that can allow you to offset risk, so it doesn't
have to be all doom and gloom.
It is something that naturally is considered to be a more.
pessimistic view of something, but at the end of the day,
as traders we're taught to be emotionless.
We're just deciding on calculations where we expect something
to go. We don't really care if it's up or down, as long as it goes
where we expected to go, because if it does, then we have the
ability to make money, and one of those ways that we can do
that is by using our short sell when we expect a downturn.
Until next time folks, please make sure you click that
like and subscribe button down below.
I will see all of you very soon.
and until I do, good luck in the markets folks. Cheers, everyone.