Short selling is a technique that is used by the advanced stock traders. The aim of the trader is to look for stocks that are not doing well in the market. This thus goes contrary to what is taught in the textbooks which are to look for stocks to buy that look promising to give returns in the future.
The short seller will look for the stocks that he wishes to sell. He will sell the stock that he thinks will fall in price in the future. The short seller basically sells the stocks that he does not own. When the price of the stock drops in value as he had predicted then he buys back the stocks and the difference between his sell price and buy price is his profit. Read this explanation to know how to short sell in Bitcoin futures.
Short selling a stock in the market
Suppose you think that the price of stock “ABC” is going to fall in the future. You thus sell short its stocks in the market. Your broker needs you to maintain a margin amount that is used to meet the requirements of deposit. The broker then sells your desired quantity of stocks ABC out of his own inventory. He may also borrow the shares from another broker or customer.
The broker needs you to keep the margin so that the original owner of stocks ABC share is protected. You will not earn any interest on this money. Also if the stock that you have short sold declares a dividend then the dividend amount does not come to you but to the owner of the stock.
Risks involved in short selling stocks
If you do not control the short sale of the stocks and the price of the stock rises dramatically then the broker with either force you to put more money into your account or he will forcibly buy the stock without taking your consent.
If the price of the stock rises in value then you can lose a lot of money. Without the broker, it is possible that you may end up losing unlimited money. If many short sellers are covering up their position in that particular stock then the stock’s price will go even higher. This is what is known as short squeeze.
A short squeeze is also possible when the traders who own the stocktake the stock from the margin to the cash account. This reduces the number of stocks that are available for the borrower and this lets the brokers buy the shares that the account holder has shorted. The expense is borne by the account holder.