What is Short Selling
Short selling is a trading technique that allows the investor to take advantage of falling markets without waiting for the drop to end, to enter the market.
Advantages of Short Selling
Short selling has two main advantages for the investor, as he gets an opportunity to speculate and take advantage of different market conditions, whether it is rising or falling. Short selling is also used to hedge buying positions and manage risks if the prices of the assets you own fall and you prefer to keep them.
- Speculation using short selling:
Short selling is a popular way to allow traders to take advantage of different market conditions, whether bullish or bearish. Many speculators tend to sell short because they believe that the decline is faster than the rise in the financial markets. Fear controls the trader, which makes the opportunity to benefit from the decline and achieve higher profits.
- Hedging using short selling:
Investors who want to take advantage of the market's rebound phase while maintaining their positions can use the method of short selling, which allows them to take advantage of the short-term price rebound while retaining a long-term uptrend. At the same time, investors use short selling to cover price differences during the forecast period for important news that may significantly impact the market to mitigate the risk of a rapid price drop.
Disadvantages of Short Selling
For short sale the disadvantages are:
- Unlimited Risks
One of the main risks of short selling is that there is no limit to the risk that investors take when the price of the assets sold by them rises, especially if the purpose of short selling is speculation and not hedging. It can drop below zero, so the risk of loss due to rising assets is considered unlimited compared to the risk of decline. Therefore, investors who take advantage of short selling are at risk of incurring losses that may exceed the value of their total capital and could become indebted.
- Dividend Risk
Because companies announce specific dates for who is entitled to receive dividends, stockholders are limited to a specific date, usually the date of a general meeting, and are eligible to receive dividends in this case. In the case of a short sale on a date before the dividends maturity date and selling the stock after the expiry of the maturity period, the short seller becomes debited with the value of the dividends, which may be greater than the value of the profits obtained from the decrease in the price. As a result of the decrease in the price, the short sale has achieved profits, but he lost it in exchange for paying the dividend compensation that the share was entitled to.
- Sudden Retail Risk
Some companies divide themselves for several reasons, such as separating the company's non-producing units from the company's profitable units, which leads to the company's transformation into two or more companies. In this way, the short seller becomes debited by several shares for each share he sold from the basic company, which exposes the movement of the two companies to move in a different direction, leading to doubling the risks of the position. Therefore, the loss resulting from the increase in the price of the first company is higher than the profit achieved from the decrease in the price of the second company.
Possibility of Short Selling
It is very difficult or even impossible to accept someone to lend their shares individually to another investor. Here, investors use two main methods of short selling, either through stockbrokers or CFDs.
- Short selling through a broker
In this case, the broker supplies the investor with the assets, and the transaction is credited to the investor’s account. The investors can only move positions through trading brokers by providing the trading broker with guarantees against loss in margin.
If the value of this insurance decreases, the investor has reached the margin claim stage or the margin warning stage. The investor must choose to close the short-selling position or accept the loss by deducting it from the investor’s margin balance. Still, if he wants to continue the position, he must increase the amount of margin available in his trading account with the broker.
- Short selling through CFDs
CFDs are contracts used to profit from price differences without actually owning the underlying asset.
The contract for difference is priced through the secondary market or over-the-counter trading. Therefore the price includes all expenses and costs related to the asset, and the price is adjusted based on any additions or discounts to the share such as dividends and others.