Have you ever thought of a trading strategy with the help of which you, as an investor, can get profit from a decline in a stock’s price? It’s ‘short selling.’ But how does this strategy work? First of all, the traders need to borrow stocks they do not own. And, what next? Let us step into this in-depth guide to understand the procedure of short-selling stocks.
What is Short Selling?
Before understanding what are the mechanics of the strategy, it is very important to know about short-selling stocks. In short selling, an investor generally borrows shares of a stock they believe will decrease in value over time. After that, the investor sells these borrowed shares at the current market price. Now, you might question how this technique is profitable for investors when they have sold their shares. After selling, the investors aim to buy back the same number of shares at a lower price. And then, they return them to the lender. Whatever difference comes out here is the profit in the hands of the investors. If you are thinking of a loan on stocks at this point, it is very different from this mechanism of short selling. How? In stock-based lending, the borrowed amount is secured against the stock portfolio rather than the stocks being sold short.
Step-by-step Procedure for Short Selling Stocks
The process of short selling involves the following steps:
Open A Margin Account
First of all, you need to have a margin account with a brokerage if you want to borrow stocks for short selling. Why is there a need for a margin account? Because it will allow you to borrow money from the brokerage to purchase securities. Having a margin account is very important for short selling as it will work as the required base to borrow stocks. Now, you might correlate this margin account with the margin accounts related to stock loans. But, both of them are different from each other. This process is different compared to asking how much can I borrow against my stock portfolio through a secured loan.
To open a margin account, you need to choose a reputable brokerage that provides similar accounts. Then, you might be asked to fill out the necessary forms and provide financial data. After providing all this and depositing the required minimum balance, your margin account will open.
Locate Borrowable Shares
Keep in mind that not all stocks are available for short selling. The brokerage must have or be able to locate shares that can be borrowed. In financial terms, this process is known by the name “locating” the shares. It is a part of the stock loan services provided by many brokerages. Now, let’s understand how to do the same. Firstly, you need to use your brokerage’s platform to check whether your shares are available for short selling or not. In this case, the brokerage may provide you with a list of stocks that you can borrow easily. In case it would be difficult to borrow, the brokerage will need to find shares from either other clients or other brokerages.
Borrow the Shares
After locating the shares, your brokerage will borrow them. Yes, on your behalf. This process of borrowing the shares is completely different from how does stock lending work for a traditional stock loan. In the latter case, stocks are used as collateral. But here, the brokerage will borrow shares from the margin account of some other client or an institutional investor. How to do it? Simply, you have to request through your brokerage’s trading platform to short-sell a particular stock. Once the brokerage confirms the availability, they will borrow the shares. And then, you can sell the shares at the current market price. Ultimately, the funds will come to your account in the end.
Monitor the Trade
The process does not end here after selling the stocks. Now, you need to monitor the market very closely. Why? Because we need to buy back those shares at a lower price. That’s why there is a need for careful analysis and timing, similar to the way you estimated the interest rate for borrowing against a stock portfolio in the case of a stock-secured loan. All you need to do is keep track of market movement and any news related to the stock. You can set stop-loss and take-profit orders to manage the involved risks. Also, during this period, be aware of any margin requirements and do not skip potential margin calls.
Buy Back the Shares (Cover the Short Position)
Now, as the stock price drops to your target or aimed level, it’s time for you to buy back the same number of shares you sold in the starting. This approach is what we call “covering your short position.” All you need to do is place a buy order for the number of shares you want to return. Then, make sure that the buy order is executed at or below your target price. And in the end, return the purchased shares to the lender with the help of your brokerage.
Return the Borrowed Shares
After you cover your short position, it is time to return the borrowed shares to the lender. And, the difference arising here between the selling price and the buying price is your profit. But yes, that profit will exclude any interest and fees.
Selling Price – Buying Price = Your Profit (excluding interest + fees)
You need to confirm from the lender if they have received the returned shares. Then, you have to review your account statement to calculate the profit and loss. In the end, if there is any associated interest or fees with borrowing the shares, you will have to pay that too.
Risks With Short Selling Stocks
Similar to stock loan services, short selling also comes with associated risks and considerations. First of all, it has unlimited loss potential in case the stock price rises a lot. After this, there are chances that you may face margin calls (similar to stock loans by many stock loan companies). The call will require you to either deposit more funds or cover the short position prematurely. Thirdly, if you borrow shares, interest and fees are also there. This might eat up your overall profits. And then, short selling is subject to regulations and restrictions as well. You need to be well-versed in them to not get impacted a lot while executing trades.
Conclusion
When one goes for short selling stocks, the process includes so many steps. From opening a margin account to managing the trade properly, each step is the cornerstone of the procedure. But, the risks are also there. And, the good news is that you can overcome the risks with a profitable financial strategy.
