How Does Short Selling Works?

Short selling homeSometimes the short sellers are the black sheep of the investor community. Short sellers play a remarkable role in expressing their opponent opinion. They act as neutral to high spirit in the market. Typically when short sellers become the subjects of regulatory inspection during the sharp market contractions, then they are directly responsible for these rapid market moves downward.  

What is short selling?

Short selling sounds like an old proverb that “buy low, sell high”. Keeping in the mind that a stock’s price will drop a short sellers perform this action in reverse; first they sell high then they buy low. The tricky of short selling is that short seller does not actually own the shares they want to sell. Short selling is the sale of a security that is not owned by the seller or seller has borrowed that property. Short selling in being motivated by the belief that a security’s price will reduce enabling it to come back a lower price to make a profit.

How does short selling works?

Unlike the buying common stock in which it is possible to find out a position and hold indefinitely, short selling requires the sellers to keep an eye on the market since they losses on any short position are theoretically unlimited. Here are some of the basic actions that short selling performs.

Borrow shares: – To get a profit from a decrease price of a stock, a short seller borrows the shares and sells those shares, and expect that these shares will be cheaper to buy back in the future. The owner does not notify the shares that are loaned by the short seller, but this action does not hinder the owner from selling at any time.

Creates a liability: – After borrowing the shares the short seller should return those shares at a later date. When a short seller decides that the time is right and motivated and strongly encouraged with buy in then the shares are purchased in the open market and returned by settling the liability.

The risks of the short selling: –

When the short sellers are short common stock then, they face several kinds of risks. First of all they have market risk which simply corporate action when short sellers are short the stock. Some of the common risks are as under;

Market risk: – The market risk which short sellers face is potentially unlimited because there is no limit that on how high stock can go. The higher the stock price goes the more pain short sellers feel.

Dividend risk: – The risk of corporate actions is serious risk. When a company decides that it will pay a dividend then company declares a record date. The record date is that date when the company takes attendance of all the shareholders who receive the dividend. Once the record date is decided the ex-dividend date is usually set for two business days prior to the record date. At this point there is a twist for the short sellers; if short sellers are short the  stock at the market close day before the ex-dividend date than the dividend will be deducted from their trading account and will be paid to the owner of the shares.

Rules for the short selling:-

There are a number of restrict rules which stocks may be sorted and the necessary conditions for shorting. According to these rules short sellers are not allowed to short any stock whenever they want.

Margin requirements: – The short sellers must have 100% of the security’s current market value in their account. This is the cash which short sellers received from the initial short sale or nay increase which may have occurred to date. As there is a liability attached to the receipt of the cash so short sellers are not allowed to spend it.

Margin calls: – When the value of the stock which short sellers shorted increases when their trade is open, then the company may require the short sellers to pay more funds or margin-able securities to cover the additional risk. This is known as margin calls and it happens when the trade moves around the short sellers.

What benefits do short sellers bring to the market?

Short sellers play an important role in the efficient matching of the buyers and sellers. Short sellers simply express their opinion that the market value is about to trend downward. The argument opinions help everyone to better understand the all sides of an issue. Similarly short sellers help all investors to understand the full range of opinions and views about a particular stock and this process is known as price discovery. Short sellers act as a run counter towards the market’s natural bias going long by providing the debatable opinions that challenge the standard wisdom. As a result short sellers help to keep the market in balance with their opponent and debatable opinions.