What is stock short selling and how to make money on short positions

Many investors who are beginning to make their first investments in the stock market would like to profit from the rising stock prices. Their primary goal is to purchase shares at a lower cost and then sell them at an expensive price. The difference between the price paid and sale is classified as income. This kind of behavior in the market for stocks is known as long or long positions and those who bet on the rise in the stock market will be known as “bulls”.

But, you can make money not just on growth, but also in an autumn. This is the reverse of a long-term strategy and can be referred to as Short sale, or naked sale. Investors who put bets on the fall market are known as “bears”.

Long


It is an exchange transaction when an asset is bought to resell it at a higher price. If after opening the trade the price of the asset starts to rise, then the long becomes profitable. If cheaper, then unprofitable.

Trading long positions is a traditional way of making money on the stock market, which is easier to understand. Conservative investors who invest money for the long term and hope for the growth of quotes are also called bulls. Traders or stock speculators also win in the long run. Because inventory growth doesn’t have to wait years.


Short


A short position on the stock market is a transaction aimed at obtaining a return on a fall in the value of an asset that the investor does not own, but borrows from a broker, that is, a company that provides all the transactions on the stock exchange.

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Short positions are called short positions because their duration is shorter than that of long positions. Stock market declines are often stronger than growth. As a result, deals close faster. People who invest for the long term do not take such positions. Basically, this is done by traders.

Short selling – what is it?


In simple terms, these are gains on the decline in the value of the securities. If a trader thinks the price of a stock, currency or other financial asset is going to fall, he borrows it from a broker, thus starting to sell short, that is, waiting for the price goes down.

Example: an investor takes 100 shares of a company and immediately sells them for 200 rubles per share. He receives 20,000 rubles in the account. Then the price decreases, and within a week the price of these shares drops to 150 rubles. At this level, the investor buys back the same 100 securities on the stock exchange. He spends 15,000 rubles for the purchase and returns 100 shares to the broker, keeping his earnings of 5,000.

In fact, the investor is borrowing assets not from the broker, but from other investors who have authorized the brokerage firm to use their shares to provide short positions. They get a small percentage for that.

At each stage of a short position, the trader pays commissions on transactions. This must be taken into account when calculating the expected return. If you managed to make a profit, you will also have to pay personal income tax.

How to sell short


Since October 1, 2021, the Central Bank of the Russian Federation has forced brokers to test clients who want to make money from falling. To do this, you must pass a special test or have the status of an accredited investor.

It is technically easy to open a short position. If, when buying a stock in a long position, you click on the “Buy” button in your personal account or application, then when you are short, you must select the “Sell” button. Even if you don’t have these assets in your account.

Then the price and the number of lots are indicated. For example, 1 lot of Gazprom shares equals 10 shares. This is the minimum available amount of securities that can be sold short. After that, negative lots are credited to the balance, i.e. not 10, but minus 10.

Then the funds from their sale on the exchange will be credited to the account. You cannot manage them. They remain virtual, because the broker blocks them so that the trader does not withdraw money from the sale of securities that do not really belong to him. The funds will be blocked until the borrowed shares are returned.

If the stock price falls to the expected values, the short position is closed. To do this, you need to buy a similar number of shares on the stock exchange. They will automatically pay off the debt.

Shorts require collateral – a certain amount of money or amount of liquid securities in a brokerage account. It will serve as collateral. In this case, the broker may allow you to open a short position for an amount greater than the margin. This is called leverage or margin trading. If you have absolutely no money in your account, you cannot open short positions in the stock market.

The broker lends shares because he earns. He takes the assets of the clients at interest, which allowed him to do so. This is called night trading – it can be turned on or off in your account. Then it issues those assets to a trader who plays for a drop, but charges a higher percentage for use. The percentage is in the tariff plan.

Interest on the use of assets accrues daily and is calculated in annual terms. The fewer days a short position is open, the lower the commission you have to pay for using securities. If the transaction is closed on the same day, you will not have to pay interest.

What stocks can be shorted


Not everything can be short-circuited, because the broker insures against large losses and only lends stocks that meet certain criteria. It generates a special list of margin securities, which may differ for clients with different levels of risk.

The list can be found on the broker’s website in the section with other company documents. Each stock, bond or currency has its own level of guarantee – the risk rate. The percentage for long is the probability of growth, the percentage for short is the probability of fall.

Example: an action costs 100 rubles. The short rate is 25%. This means that you must have 25 rubles in your account to complete a transaction and open a position. If you want to buy not one, but ten shares, the account should contain 250 rubles.

Usually the broker allows you to short sell the securities of top-tier companies – the largest and most liquid organizations on the exchange. The broker does not permit the short purchase of securities of Tier 2 and Tier 3 issuers.

When markets are highly volatile, brokers may prohibit short selling of all assets. This was the case during the financial crisis of 2008 and the geopolitical crisis of 2022.

During stock market fluctuations, it becomes unprofitable for a brokerage firm to allow short positions. Moreover, it could further shake the situation and increase the pressure on the stock market.

Short risks


If panic reigns in the stock market and the news announces another collapse, it seems to many that it will be profitable to buy a stock short. However, any prediction, especially in times of uncertainty, may not come true. Short trading is associated with increased risks.

When you buy a stock hoping for growth, you can completely lose all the money if the company goes bankrupt. At the same time, the probable return is not limited. A company can grow without limits if it succeeds in expanding its business, launching new products and conquering new markets.

When opening a short position, the situation becomes a mirror image. Potential gains are limited, as the stock cannot fall below zero, and the loss is unlimited.

Example: an investor sells 10 shares short at a price of 1,000 rubles per share. For the sale, he received 10,000 to the broker’s account, which he must return later. The investor expects stock prices to fall, but instead they begin to rise. Now each costs 1,500 rubles. To close the position, he needs to buy back 10 shares, but for 15,000. Thus, he receives a loss of 5,000 rubles, excluding brokerage commissions.

Of course, a trader cannot abandon his strategy hoping that prices will fall further. But the value of the stock can increase even more, as well as the amount of the loss.

When at any time the losses of a short position against the trader’s deposit approach a critical level, he will receive a margin call. This is a situation where the broker requires either to enter into a short sale and return the money, or to deposit funds into the brokerage account so that their volume covers the losses.

If the margin call requirement is not met, the broker will forcibly close the short position at the current prices. This usually happens if the price goes more than ⅓ against the position taken by the investor. Then the losses can no longer be recovered.

Short action before dividend cut


If a company pays dividends, before paying them, it sets a date of closure of the register (dividend cut-off). On this date, the list of shareholders benefiting from the payment is drawn up.

The day after the cutoff date, a company’s stock almost always drops by the amount of its dividend. This process is called a dividend spread. In the future, the price of securities returns to previous levels, but this may take several months.

The dividend spread is a well-known process in the market. It looks like you can open a short position before the deadline, wait for the stock to drop afterwards, and you’re guaranteed to make some money. Unfortunately, that won’t work. Brokers have developed a special mechanism for this case.

If you have a short position at the time of the close, the investor who authorized their stock overnight will not receive a payment. Therefore, the broker will require you to pay dividends to them, as well as cover personal income tax. True, most often brokers close short positions themselves, not allowing them to be held during the limit period.

Summary


  • A short circuit is possible if there is the necessary amount of money or securities in the account to guarantee the transaction.
  • Not all shares are available at short notice. Brokers publish the list of authorized brokers on their website.
  • Basically, a short is a loan. You borrow money and it earns interest.
  • A short position is an increased risk. It is difficult to predict the fall of individual companies and the losses can be limitless.
  • You cannot go short before the dividend cut. The broker will either close your position or require you to pay dividends.

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