[Short Selling] Ways to Survive a Market Crash
Short selling is a concept that many friends have heard of, but few people are able to make profits through short selling during bear markets. This article will discuss short-selling, including its risks and benefits. I hope you will have a better understanding of short-selling after reading this article.
1. What is short selling？
Short selling is a trading strategy that speculates on the decline in a stock or other security's price.
According to the image from Motley Fool's website, short selling is to borrow shares of a stock or other asset that the investor believes will decrease in value.
You borrow the stock from the brokers with a certain amount of funds as a guarantee to sell, and when the stock falls, you purchase the same number of stocks at a lower price and return them to the brokers.
Imagine a trader who believes that ABC stock—currently trading at $100—will go down in the next months. He can borrow 100 shares from the brokers and sell them to another investor.
A week later, the stock falls to $50. The trader decides to close the short position and buys 100 shares at $50. The trader’s profit on the short selling, excluding commissions and interest on the margin account, is $5,000 ( ($100 - $50 ) x 100 shares = $5,000).
2. Why short selling？
There are two main motivations to short:
1. To speculate
The most obvious reason to short is to profit from an overpriced stock or market. The most famous example of this is when George Soros broke the Bank of England in 1992. His profit from short selling eventually reached almost $2 billion.
2. To hedge
Most investors use short positions as a hedge. This means they are protecting their long positions by shorting other similar stocks.
3. How to short selling？
In order to use a short-selling strategy, you have to go through a step-by-step process:
- Identify the stock that you want to short.
- Click the "Trade" button and then the "Sell" button. (Make sure you do not hold long positions in the same stock)
- Enter your short order to choose the appropriate number of shares.
- At some point, you'll need to close out your short position by buying back the stock that you initially sold.
4. Pros and Cons of Short Selling
1 Possibility of high profits
It has been mentioned before that short selling can be beneficial in a bear market.
Furthermore,when companies are involved in financial scandals or crises, their stock prices tend to fall rapidly.
For example, Luckin's stock fell 75% in April 2020 after its Chief Operating Officer admitted to fabricating a significant portion of the company's sales. Short sellers can make a fortune from shorting.
2 Hedge against other long positions
Some investors use short positions to protect (hedge) against the risk of a declining asset/stock price in the future.
1 Potentially unlimited losses
Short selling can be costly if the seller guesses wrong about the price movement.
A trader who has bought stock can only lose 100% of their investment when the stock decline to zero.
However, a trader who has shorted stock can lose much more than 100% of their original investment since the equity prices can continue to go up, and the risk of "short" is theoretically unlimited.
2 Margin call
Shorting is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokers using your investment as collateral.
If the value of the collateral in your margin account drops below the minimum requirement, the broker may require you to deposit more cash or be forced to close it by buying back the stock to cover the difference immediately.
3 Margin fees incurred
There are a number of fees associated with short selling in addition to commissions, such as margin interest and dividend fees.
Margin interest can be a significant expense when trading stocks on margin. Short positions can accrue interest over time if held for an extended period of time.
In addition, short sellers need to pay dividends on shares that they have borrowed. The dividend will be deducted from the short seller's account on the payment date and delivered to the stock owner.
4 Recall risk
In certain situations, a short position may be covered without being directed by the position holder.
When a stock has a high percentage of short positions, there are no more securities available in the short pool, and the lenders who originally held these stocks are seeking to close out their positions. The brokers may recall the shorted stocks from the holders and return them to the lenders.
The Tiger Trade app provides key information about shorting pools, short interest, and other metrics which are key to short selling.
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