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The Basics Of Short Selling Stocks

‘Shorting’ or short selling refers to the selling of a contract, a bond or stock or a commodity that is not directly owned by the seller. When practicing short selling, a seller is committed to purchase the stock or commodity previously sold.

Short selling stocks means to take the stock from a broker on loan and sell it off to someone else. This is done so that the seller buys back the stock, when the price falls. The shares are returned to the broker from whom they were initially borrowed. The shorting profit or the difference in price goes to the seller. Short selling of stocks is a technique used by investors to capitalize on a probable decline in the stock price.

To understand this better, let us consider a company, say, ABC whose shares currently sell at $12 each. A short seller borrows 50 shares of ABC and then sells those shares to someone else at $12 per share, for a total of $600. Now, if in future the price of shares of ABC falls to $10 per share, this short seller would then buy back those 50 shares at $500 ($10 multiplied by 50 shares), send back the shares to the original owner/broker and make a profit of $100.

Short selling is risky, if the price per share goes up instead of declining, as expected. Suppose the price per share of ABC goes up to $15 per share, then the short seller will have to cash in the previously sold 50 shares at $750, return the shares to the original owner and incur a loss of $150.

Shorting is a transaction done on margin. Most brokers do not agree to short selling stocks below $5. This enables the investors and short sellers to indulge in the high-risk trading of stocks.







Some of the following market situations help to predict a fall in price of stocks: -

- Market indexes coming near the prior resistance levels.
- Market trend showing technically overbought levels.
- Restlessness before the announcement of a state’s government.
- Market vulnerability during scandals.

Large volume selling of stocks often result in short-term high profits. However, there are certain guidelines to be followed for successful short selling. They are:

- All stocks are not ‘short’ able. Generally, brokers inform a seller whether a stock can be used for short selling or not.

- Sellers must open a margin account for short selling. This depends on the minimum balances and cash reserves. Sellers are required to sign a contract agreement with the brokers to open a margin account. This agreement clearly states that a seller will follow the rules and regulations stated by the broker.

-Target bad-performance, overpriced companies, since the probability of a fall in the share price involves lesser risk.

- Traders and short sellers should use stop orders to protect their capital from loss. Generally, brokers prevent a seller from suffering loss more than the principal. They may either compel the seller to quit the transaction or they may deposit funds to increase the seller’s capital.

The short selling of stocks involves a lot of discipline. Sellers need to be proactive, alert and disciplined when shorting stocks.

12 comments:

  1. I wonder if you can apply this to something else. It is a neat selling method I would say.

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  2. Ever since I saw the film 'The Big Short' I have been paying attention to the stock market. Short selling seems like an interesting but risky way to earn money.

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  3. Short selling stocks is novel to me though....This write up sure opened my eyes to a whole new concept.. Spot on

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  4. Facing risks smartly will let you reap better rewards. Looks like this is the case of short selling. It's definitely something interesting to try.

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  5. In business or the investment world, it is always run by risks. The more you risk, the higher the returns.

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  6. Short selling is a smart money making technique. However it requires a keen seller who is always up to date with market trends.

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  7. I always rely on market vulnerability during scandals when looking for short sell opportunities. It almost never fails.

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  8. Short selling is a good method I believe that can enable a trader make quick cash but what must really be up with the right market information to achieve this

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  9. Great read! Thanks for teaching the basics and making it so much easier to understand short selling. As with any move, I understand it's risky as you mentioned but I think it's worth taking it from time to time.

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  10. When practicing short selling you have to be extremely cautious. It is very easy to end up making a loss instead of a profit.

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  11. In case there is a loss it seems the seller is the one who is likely to suffer the most. The broker will still get his or her capital back. Great insight.

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  12. Now I know what a short selling stocks is. Thanks for simplifying its definition and for giving a clear example. Good article!

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