Most of the time investors buy shares in a company because they believe the share price will rise. You buy as low as you can. Then you hope the share price rises. You’ve probably heard the expression ‘buy low, sell high’. But what if you expect a share price to fall? That’s where short selling comes in.
I know short selling sounds complicated, but it isn’t. In fact, there isn’t a lot of difference between short selling and buying shares. If there is one big difference it’s this: when you sell a stock short you are SELLING the stock first and BUYING it second. This is the opposite of a normal share transaction where you are BUYING the stock first and SELLING it second.
Let’s look at how a hypothetical trade is structured.
Stock: XYZ Ltd
Short Sell at $5.00
Initial target: $4.00
Note how the initial target price is below the current share price. Because we want the share price to fall, our first profit opportunity comes when the share price trades below $5.00. In this example, you expect the price to fall to $4.00. Based on this, you would make a 20% profit, if the price moves as you expect.
If you can’t grasp the concept of how you can sell something you don’t own, let me give you an understanding by explaining what goes on behind the scenes when you ask your broker to short sell a stock for you.
The following is how a conversation with your broker could sound:
“Hello, this is Big Money Brokers.”
“Hello, I would like to place a trade to short sell XYZ Ltd shares, but can you give me the current price first?”
“OK, please can I have your account number?”
“My account number is XXXXXXXX.”
“The current price of XYZ Ltd is $5.00. How many shares of XYZ Ltd would you like to short sell?”
“I would like to short sell 1,000 shares of XYZ Ltd at a limit price of $5.00 please.”
“OK, I’ll need to make sure that we can borrow the stock. Are you able to hold?”
“Yes, that’s fine.”
At this point the broker needs to check with his back office people to make sure they can borrow shares of XYZ Ltd. Why? Here’s where knowing the mechanics of short selling is useful. When you’re short selling you don’t actually own the shares in order to sell them. So, what do you do?
As you don’t own the shares, you’ll need to borrow them from someone who does. Your broker will contact his back office to find out if the shares can be borrowed.
The broker’s back office will contact a financial institution such as a bank and ask them if they have 1,000 shares of XYZ Ltd they can borrow. If they do they’ll send those shares electronically to your broker. Once the broker has received confirmation from his back office that the 1,000 shares of XYZ Ltd have been borrowed the broker can relay that information to you…
“We can borrow 1,000 shares of XYZ Ltd. Would you like to go ahead and short sell 1,000 XYZ Ltd at $5.00?”
“Yes, please go ahead and short sell 1,000 shares of XYZ Ltd at a limit price of $5.00.”
The broker will either confirm the trade has been completed immediately or he/she will send you a confirmation later that day.
“I can confirm we have short sold 1,000 shares of XYZ Ltd at $5.00 for a total amount of $5,000 less commission of $50.”
You hang up the phone having completed the trade.
So, what happens next? Well, you now wait for the shares of XYZ Ltd to fall to the initial target price of $4.00.
When this happens you contact your broker to take the profits…
“Hello, this is Big Money Brokers.”
“Hello, I have a short position of 1,000 shares of XYZ Ltd; I would like to place an order to buy back the shares to close the trade. Please can you give me the current price?”
“Sure, what is your account number?”
“My account number is XXXXXXXX.”
“OK, you have an open short position of 1,000 shares of XYZ Ltd. The current price of XYZ Ltd is $4.00.”
“Thank you. Please cover my short position by buying back 1,000 shares of XYZ Ltd at a limit price of $4.00.”
“No problem, just confirming you would like me to cover your short position by buying back 1,000 shares of XYZ Ltd at a limit price of $4.00.”
“Yes, that’s correct.”
Your broker will either confirm the trade with you immediately or he/she will send you a confirmation later that day.
“I can confirm we have bought back 1,000 shares of XYZ Ltd at $4.00 for $4,000, plus a commission charge of $50. Your short position is now closed.”
“Thank you, goodbye.”
That’s it, the trade is complete. You sold the shares at $5.00 and then you covered your position by buying back later for $4.00. “Covering” your position just means that you’ve bought the shares on the market to close the trade. The difference of $1 per share is your profit. You ‘sold high’ and ‘bought low.’
Now, as far as you’re concerned the transaction is complete. But for the broker there’s one extra step for them.
Remember that the shares you short sold weren’t yours. You borrowed them from a bank. Well, when you borrow something you need to give it back eventually.
And that’s exactly what your broker will do. After the shares have been bought back through the stock exchange the broker’s back office will arrange for the shares to be transferred electronically back to the bank.
Hopefully by now you’ll see how simple it is. Short selling just means selling the stock first and then buying it back later. The difference is your profit.
Of course, if the share price goes up after you’ve short sold then you lose out, as you have to cover your position (buy the shares) at a higher price.
Some investors think short selling is unethical. After all, you’re betting that a share price will fall. Does that seem fair?
Of course it does! Short sellers often provide a valuable service. Wall Street and Collins Street are often an enormous hype machine, determined to sell investors stocks even if the companies themselves have doubtful prospects for long-term success.
Short sellers help alert other investors to particular cases where a company is being mismanaged. In recent years, short sellers have been some of the first to uncover fraud at major companies like Enron. And experienced investors often use short selling as a way to hedge their portfolio, which is generally biased toward buy-and-hold (or bullish) investments.
All the best,
Technical Analyst, Slipstream Trader
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