What exactly is a short, or a short position?
A brief introduction, stocks prices constantly move up and down. There is a variety of factors that drive stock prices, but ultimately the price at any given moment is altered based on stock’s supply and demand in the market.
Many believe that the price of a stock is determined by company’s financial statements, analysts’ forecasts and quarterly results. If that were to be true, stock prices would not be likely to have drastic changes over short periods. During one trading day it is very unlikely, that a stock will keep its price for more than a few seconds. How does this actually happen?
Every company traded on the stock exchange has a limited amount of shares, that is, when you buy an Apple share (AAPL) you buy it from an investor alike, rather than Apple Inc. This investor, earlier, bought the stock from another investor for profit, and is now happy with selling it. Therefore, every transaction on the stock exchange is made between two parties, one who believes that the current price is low and another who believes that the price is high. So, the two parties agree to make an exchange.
Back to the beginning, stocks prices constantly move up and down. Over decades, trading experience has improved, allowing investors to anticipate stock trends, using technical analysis.
Technical analysis is a tool that can help investors study the chart of a stock in an attempt to forecast future price movements before it occurs.
The disciple of technical analysis is based on 6 different principles, with the purpose of analyzing the market sentiment behind price trends. For example, the price of stock has raised from $60 to a $120 over two weeks, quite impressive. If you had bought the stock two weeks ago, with an investment of $15,000, you would have doubled that investment amount in only two weeks. At this point there are two options: hold the stock with the assumption that you are holding a dream stock, which will continue rising, or detach from any sentiment and sell the stock to realize the profit.
- Stock prices are driven by supply and demand and indicate the current value of the stock to buyers and sellers.
- Any transaction on the market is between two parties, based on an underlying belief that a certain stock is overbought (expensive) or oversold (cheap).
- The number of stocks on the market is finite.
In the example of stock X, which has risen 100% in two weeks, we may assume that a price drop will follow, since many investors will be willing to sell the stock to realize the return. Using technical analysis, we anticipate that over the next two days the stock is expected to decrease in value.
An investor may profit from the price drop of a stock, by short selling the stock. In short selling, a position is opened by selling a stock the investor does not hold. While a long position is created with an intention to buy low and sell high. A short position is created with the intention to sell high with an expectation of repurchasing the stock at a lower price later.
Understanding Short Selling
Short sales are executed by borrowing stocks from a brokerage firm.
A brokerage firm normally has a large inventory of stocks, since it has many customers who hold stocks with them. Some of these customers hold stocks in their portfolio over several years. Therefore, when opening a short position, brokerage firms will typically lend you the stocks from the account of another investor.
This process is handled by brokerage firms behind the scenes and is seamless to the one opening the short position. Opening the position is done through the trading platform, in a click of a button, usually SELL or SHORT.
Using this trading technique an investor can short sell the stock X at $120, anticipating that the price of the stock will fall and make profit from the price difference. For example, if the price of stock X decreases from $120 to $100, the investor will gain $20 on the short trade. In essence, the investor borrowed the stock and sold it to another investor for $120. The investor holds $120 and a debt to the broker for 1 stock lent it to him. Once the stock’s price falls to $100, the investor buys the stock with the money gained in the initial sale, to replace the borrowed stock. The stock is returned to the broker, while the investor profits $20 from the transaction, minus any commissions paid to the broker for executing the transaction.
On the other hand, an investor may also incur loss from a short position. In case the price of stock X increase from $120 to $125, the investor will need to add more money to buy the borrowed stock to return to the broker. In such scenario, the investor will lose $5 on the transaction.
Therefore, short selling is profitable when the stock decreases in value with a risk of loss shall the stock value increase.
Short selling is considered a high-risk trading activity. Investors willing to venture in short selling are recommended to learn professionally how to use this trading technique correctly and responsibly.