What Is Shorting a Stock? Theory and Examples
Speculation is a primary type of investment. Speculation happens when a trader makes a purchasing or selling decision because they believe a stock is going to behave in a certain way in the near future.
While speculating on the growth and increasing cost of stocks is called ‘long trading’, speculating on the recess and the decreasing cost is called ‘short trading’, which is much more complex and dangerous. So, what is shorting a stock, really?
How does shorting work?
Betting on the declining value might be counter-intuitive, but it’s actually a very profitable activity if you know how to navigate it.
In order to short a stock, you’ll have to take several steps:
- Borrow the shares you need on margin from a broker;
- Sell these shares like you usually would;
- Wait until the value declines;
- Buy the same number of shares back;
- Return the shares to the broker;
- Keep the difference.
Your ideal situation would be for the stock to keep falling in price. However, if it suddenly soars above the value at which you borrowed the shares, you’ll have to buy them back at a higher cost. It means you’ll need to add money from your own pocket to repay your debt.
It’s very risky precisely because the price can just keep rising and rising, while you wait for it to drop just a little bit. This sort of investing is not for the inexperienced, and it requires a steady hand and a cold head.
How do you borrow stock?
Another danger of shorting coincides with the main risk of margin trading. To borrow shares, you act in the same way:
- Open up a margin account with the broker;
- Borrow shares instead of money – you get them from a broker, who borrows them from an issuer on your behalf;
- Manage your margin account.
The questions “What is shorting a stock?” and “What is margin trading?” are similar – you owe the broker something. Instead of dollars, however, this something is shares.
At the same time, if you traded on margin before, you know that it’s picky. You can’t just borrow a hundred dollars and return a hundred one week later. There is stuff like margin maintenance and interest.
The maintenance margin is a portion of borrowed stuff that you can’t touch. It’s always some percentage of the full sum, specified either by the government, the broker, or both. For instance, if the maintenance is always supposed to be at 20%, and you borrow $100, then:
- Your margin = $200;
- Your maintenance = $40;
- The actual sum of money you can use = $160
It’s the same with the shares, but instead of the pure money, your margin and associated portions will be shares: 200 shares, 40 of them maintenance, 160 are usable.
Due to this, many margin and short traders lend more than they need at the moment. Maintenance is simply the deadweight behind you, and if spend any of these 40 maintenance shares, you’ll be in trouble.
Interest is also very nasty. It’s usually monthly or weekly. Each time, you end up owing more shares. Therefore, every trader that undertakes shorting needs to account for interest and also maintenance margin.
However, for the sake of simplicity, let’s pretend that a broker we deal with here doesn’t believe in interest or maintenance margin.
How do you short a stock, precisely?
So, how does shorting a stock work in practice? When you lend the specific shares, you’ll need to sell them as usual. It’s a risky moment because you don’t own them, and you might not even get them back in time.
But anyway, as you sell the shares at a particular cost, you’ll need to wait until it drops. Thus, you should only target the shares that are bound to fall with a very high chance.
Unlike long trading, you can’t just wait another turn for the trades to become valuable again. Shorting can’t be long-term – you have the interest to pay back, after all.
So, say you borrowed 10 Microsoft shares, each worth $1,000. After you sell them, you’ll have $10,000 on your account.
Then, as you expected, the value of Microsoft shares drops to $900. There is not much difference, but it’s going to make all the difference. You buy 10 shares, each worth $900. What you now have is:
- $1,000 of pure money;
- 10 Microsoft shares worth $9,000 combined
Now, if you were to return all 10 shares you owed now, you’ll still have $1,000 of surplus. This money is completely yours. That’s exactly how it works, and it can work marvels. Obviously, you shouldn’t even attempt it if you aren’t very familiar with margin trading or speculative trading in general.
What is hedging?
Now that we got shorting a stock explained, let’s cover its popular subtype, hedging. Hedging and shorting are very different. However, in comparison to the latter, the former is meant as a protective measure against price drops. It’s one of the main and most common ways to manage risks.
If you aim to make a long trade but also fear that the price of this security you’re betting on can drop, then instead of betting all of your money on the positive outcome, you can allocate a portion of this capital to shorting. Then, even if the security falls in price, you’ll be able to lessen your losses thanks to the profits from your borrowed shares.
If the securities start to grow, however, then you’ll have to cut your profits somewhat to return your borrowed shares that now cost more money to buy back.
Hopefully, now the question of “What is shorting a stock?” is answered, including how it works and what risks this approach hides. It’s, by all means, an advanced strategy not just because it’s associated with more risks, but also because it can be used as a protective measure if you can handle it.Yes, I want access to free training