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Guide to "Short Selling"

posted Jan 9, 2016, 11:53 PM by Mohit Kumar

What is Short Selling?

When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Why Short Sell?

We will short sell to:

  • Speculate:  Make a calculated assessment of the market and take risks where the odds appear to be in our favor.
  • Hedge:  Protecting other long positions with offsetting short positions.

How to Sell Short?

Step 1: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says “Sell Short” or "Short Sale".

Step 3: The broker, depending on availability, borrows the shares. The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

Step 4:  Finally, when you are ready to exit the trade, you execute a "Buy to Cover" transaction of the same number of shares you sold earlier, hopefully at a lower price!

Profit / Loss Example

The Stock Price Sinks (stock goes to $50)

Borrowed 100 shares of ABC at $75

$7,500

Bought Back 100 shares of ABC at $50

-$5,000

Your Profit

$2,500

 

 

 

 

 

The Stock Price Rises (stock goes to $100)

Borrowed 100 shares of ABC at $75

$7,500

Bought Back 100 shares of ABC at $100

-$10,000

Your Profit

-$2,500

 Risks?

  •  Losses can be infinite. When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go.
  •  Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral.
  • Call could be right, but timing could go against: We may be right in our call about a stock being overvalued. Nevertheless, if the stock rises in the short run, we may be forced to exit.

Our Ethics

  • ·Short Selling is very risky! You must be well aware of that. Make these trades only if you are comfortable with the risk factor. If not, there will be plenty of promising long picks to keep you busy!
  • ·Exit at a loss of 40%:  This will be our golden rule. To keep ourselves protected, we will limit our losses to 40%.  In other words, you must exit from this trade as soon as your losses exceed 40% or more, even if a formal “Buy to Cover” recommendation is not made. This way we ensure that we do not lose any more than 40% on a short sell trade!
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