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What is Shorting in the Financial Markets?

BitForex Editor
Jan 22, 2021

Everybody in the financial markets is there to make money or profit of some sort. Although this aim is a general one, the strategy adopted by investors may differ. This is why we have different types of investors, with different methods- that works all the same. From the long term value strategy investors- like Warren Buffet to the swing traders- like George Soros who make the relatively short term trade moves, the possibilities are now becoming endless.

Shorting- as a strategy in the financial markets now ranks amongst the most adopted methods amongst investors. Although it may have become more popular in the last few decades, it is a relatively old financial market investing approach, as it was first used in 1609 by Dutch businessman- Isaac Le Maire.

Primarily, shorting not seem like what the beginner investor is introduced to, but a lot of stock market participants who use this strategy think it is worth it. Even though there are opinions and sentiments around market shorts practices, it would most likely continue to gain increased adoption amongst market participants.

How Shorting Works

Many times, when people talk about financial market investing, they tend to emphasize staying invested in the instruments for a good time. This is because there is a general perception that long term investing is the greatest path to making profits on the market. However, shorting (or short-selling) in the financial market takes an entirely different path. Over time, a lot of short-sellers have made significant profits, hence bringing cause for questions on the necessity of long term investing.

Essentially, shorting means borrowing market securities, and selling them off at a certain price- with the intent of buying them back when the prices dip. Hence, if an investor decides to short a listed stock, he simply borrows the stock from a brokerage firm- who is willing to lend it out, sell it, and waits for the general price of the stock to dip on the exchange- before buying it back. For instance, if investor X was to short 1,000 shares of company Y, he simply goes to his broker and requests to borrow 1,000 shares of company Y. If the brokerage firm approves his requests, investor X then proceeds to sell the shares. If he sold at $20 per share, he would then wait for company Y's shares to fall in price to say $15 per share, before buying it back. After buying it back, he then returns the shares to the broker- from whom it was borrowed. This way, investor Y would have made a profit of $5 each on 1,000 shares of company Y.

Note that as against the popular opinion of value and/or investing where investors buy securities in anticipation of an increase in share price, a short seller's activities are carried out with the hopes that the stock prices would fall. This means that a short-seller can talk of his profits, only if his price fall predictions come true.

However, while it looks like an easy to do, step-by-step process with prospects for profit-making, shorting requires some tact. Since the market may always show some unpredictable dynamics, short-sellers may lose money if the stock prices fail to fall. Hence, if a shorted stock keeps rising- instead of falling in price, the short seller would be required to cover up for the extra costs that would be made in buying back the shares that were borrowed. For instance, in 2018, Bill Ackman’s Pershing Square Holdings had to close a short-seller position it had opened on Herbalife shares for five years. The price fall predictions were not going in the holding company's favor, and it eventually had to cut its losses- which was running into billions of dollars. This same company had at other times, raked in massive profits from its several short-selling positions.

To know the price movement tendencies of stocks before shorting, intending short-sellers may need to observe market reactions towards a stock and also carry out some other extensive due diligence. Considering that a beginner investor may not be vast in using financial market tools like fundamental and technical analysis in determining how stock price movements could go, it is usually not advisable for them to get involved.

When shorting, note that there is usually no time frame allocations for when borrowed stocks must be returned. However, the brokerage firm may also request the assets at almost anytime, but a prior notice can be issued to the short-seller. There is also a margin interest that the brokerage firm charges on every short-selling position.

When Do Investors Short Assets On The Financial Markets?

There are a few reasons or indicators that could signal when it is most ideal for an investor to go on a short-selling business. The following are two important indicators:

When stocks become overvalued

The prevailing market valuation of stocks is one of the biggest reasons or indicators that short-sellers look out for. An overvalued stock has been overbought and is now selling at a price higher than it reasonably should. When a stock reaches a price that is deemed to be over the true reflection of what it is supposed to sell at, a short-seller may then decide to short the stocks. The idea is that at a point, there would be a market correction on the overvalued stock, and its price would eventually fall. If this happens, the short-seller may end up making a lot of profit. However, not all overvalued stocks eventually get corrected, and the short-seller may still lose money.

Observed market volatility

Sometimes, there may be too many trading activities on a stock, leading to high-level fluctuations in demand and supply. These fluctuations may consequently lead to high price volatility on the stocks, which then creates a shorting opportunity for short-sellers. If this happens, short-sellers may observe the trends using the different analysis modules and may subsequently be able to determine when to take and exit a short-selling position.

Now, while shorting is more likely considered to be risky than not, participants may gather better results over time if they can learn the ropes. Although there might still be losses, an experienced short-seller would likely make an increased aggregate of gains than losses.

Conclusion

Now, while shorting is more likely considered to be risky than not, participants may gather better results over time if they can learn the ropes. Although there might still be losses, an experienced short-seller would likely make an increased aggregate of gains than losses.

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