When entering the stock market or the Forex market, the concept of short selling is probably a phrase that investors often refer to. In finance, short sales or short selling is a business in the financial markets that is conducted for the purpose of profitability through falling stock prices.
In fact, most investors aim to buy securities to wait for prices to rise in the future, but those who trade thanks to the short-sellers make a profit thanks to the fall in the share price in the future.
You’re wondering what short selling is. How does short selling work? What is its profit and risk? All will be answered in detail through the following post. Please follow!
I. What is short selling?
Short selling is a form of downward speculation. It is about profiting from a decline in the value of securities, commodities, or other financial assets.
When making short-selling transactions, the investor expects the price to go down and borrows a quantity of securities from securities companies and must deposit, the investor commits to return those securities in the future. If the price goes down as expected, the investor is profitable, if the price goes up, the investor will suffer a loss.
Examples of short selling:
Let’s say company A’s shares are currently selling for $10 per share. A short seller will borrow 100 shares and sell them for $1,000. If that A share price then drops to $5 per share, the short seller will buy back those 100 shares for $500, pay the borrowed shares to the original owner, and get a profit of $500.
However, if the stock rises to $20 per share, the short seller will suffer a loss when it has to buy back up to $2000 for 100 shares sold to return to the original owner who borrowed it. The total damage is $1,000. Short selling is a double-edged sword, which is a way of cooking axe porridge based on the property others own.
II. Characteristics of short selling
Short selling in addition to helping investors increase profits from the downward direction of the price, but it also helps increase the liquidity of the market. Because when investors don’t have stocks, they can still borrow stocks to sell. Trading volume will increase because the market is now active in two directions, up and down, which makes market liquidity higher and makes it harder for stocks to be priced.
The nature is more complex than buying ordinary shares, the large profit is accompanied by high risk. Therefore, short selling is only allowed in developed stock markets and is limited to large highly liquid stocks.
Things to pay attention to when making short selling:
- The amount you lose will not have a price limit that keeps rising forever.
- Shorting of securities always presents market risks, such as when the price goes according to your expectations but suddenly turns and causes losses.
- When executing short orders, it is necessary to pay attention to taxes and transaction fees for more effective profits.
- The sale should not be for experienced investors who read and understand the market, new people who have not yet experienced should not participate.
- The cost of borrowing stocks for a timeout to sell will affect your profitability, so it is necessary to choose good stocks with high liquidity to limit financial losses.
III. How does short selling work?
One of the biggest questions traders have when they first learn to sell is how to short stocks when they don’t own them.
According to traditional short selling, traders will borrow shares that they do not own (usually through the stock exchange where the trader opens an account). Then, sell these stocks to the market at a price lower than the market price. The trader’s goal when shorting the stock is to then buy these stocks back at a lower price, and then return the borrowed stock. At that time, the trader’s profit is from the difference between the initial selling price of the shares and the cost of buying them back.
Since the emergence of CFDs, short selling has become a lot easier because it allows speculative traders to hoard based on the ups and downs of the market without owning the underlying asset.
Instead of investing in stocks in the traditional way, traders profit from the difference between the opening and closing prices of the stock, or the trading instrument they are using. Compared to other trading instruments, traders can easily enter and exit orders when short selling. This is one of the reasons why short selling securities through CFDs has become so popular.
IV. Pros and cons of short selling in securities/ Forex
1. Pros
- Short selling means that traders have the opportunity to make a profit not only from emerging markets but also from markets that are trending down.
- Short selling can be a big profit when it only requires less initial capital.
- Short selling can be done in a variety of ways. Thanks to the development of information technology, online transactions are on the rise.
- In particular, thanks to derivatives, such as CFDs, traders can open a long position across thousands of markets without taking the same loan action as the traditional short selling method through brokers – a method that is not yet allowed in Vietnam.
- Short selling can be used for a variety of purposes including profit speculation, taking a short position, or hedging a portfolio.
2. Cons
Short selling can be a risky strategy. Both theoretically and practically, a security asset can increase in value indefinitely or for a long time. Leveraged products can increase the level of risk even further, bringing a large loss to traders when the market price is trending up.
Traders may be subject to a recall risk, in case the securities lender wants to liquidate their position and recover the securities lent. This forces the traders who are borrowing to liquidate their positions at a time of disadvantage.
V. Why do investors short – sell stocks?
Short selling can be used for speculation or hedging. Speculators use short selling to take advantage of potential declines in the broader market. Hedgers use strategies to protect profits or minimize losses in a portfolio or security.
Note that institutional investors and savvy individuals are regularly involved in short-selling strategies to serve both speculative and hedging purposes. Hedge funds are among the most active short sellers, often making short-term profits from selected coins or sectors to protect their long-term plans in other coins.
While short selling gives investors the opportunity to make a profit in a bearish or neutral market, because the risk of losses is limitless, only talented investors should try their hand.
VI. Risks and hedging when short-selling
1. Risks of short selling
In investing, investors will have rewards when true and price movements according to their expectations. But investors aren’t always right, and it’s very likely that short selling causes huge financial losses if investors don’t know how to hedge and manage risk.
Whether you have the right knowledge and scientific basis, data, as well as an effort to evaluate a stock; But predicting a price drop after a short sale may be completely wrong. For example, your company is acquired by a much larger company and the stock price rises, or even though the oversized stock price continues to rise, or doesn’t come back as quickly as you think, or the stock is on a sudden downward trend that rises again. All such cases will cause you to lose.
The amount you lose because of short selling will be unlimited, in theory the stock can rise to infinity. While buying stocks, you lose a maximum of only 100% of the amount you invest in the stock, as the lowest price of the stock is 0 dong. The cost of borrowing shares, interest will incur a lot if you have to wait too long to buy back, which can cause you financial losses.
If short selling is rampant, which can cause great harm to the stock market and the economy, short selling only takes place in developed stock markets at a certain level.
2. How to prevent short selling stocks
Short selling is a subject of probability, with accuracy never 100%, so to limit losses, investors need to:
- Identify reasonable buying points and selling points, and identify stocks that are priced far higher than their real value to increase the likelihood of winning, and the likelihood of winning big.
- Always limit losses by certain norms, which can be at 7%-10%.
- In securities, there are always risks that cannot be measured, so investors should only sell securities with a certain proportion.
- For new, or inexperienced investors, it is best not to participate in short selling stocks for experienced investors or waiting when we have the right understanding of the stock market.
Summary
Short selling is not a strategy used by many investors largely because of the expectation that the coin will increase in value. Particularly for investors who are oriented to long-term investments, buying and holding coins is less risky than short selling. Short selling can be profitable if investors are sure that cryptocurrencies are likely to fall in the short term.
Here’s all the information about what short selling is and the issues that investors shouldn’t ignore. Understanding the mechanisms and advantages and disadvantages of this investment method will give you a higher return.
Best regards,
Ola City Global
