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Short Selling – What It Is, Why You Should Know About It, and When Is It a Good Time to Short?

“Short selling” refers to an advanced investment or trading strategy that involves speculating on the decline of a stock price or other security. This strategy should only be used by more experienced investors and traders.

When short selling, a trader will open a position by borrowing stock shares that they believe will decrease in value by a certain date in the future called the expiration date. Then, the trader sells these shares to buyers who will pay the market price. Before the shares have to be returned, the trader believes that the price will steadily decline and they can buy the shares for a lower price.

Why Should You Know About Short Selling?

Short selling is often used to help traders speculate. Some investors use short selling to make the most of a potential decline in a stock, in an industry, or in the market as a whole. Though short selling is risky, it can be incredibly lucrative if the right risks are taken.

This practice can also be used to hedge positions. Hedge funds make up a majority of active short sellers, and traders often use short positions in certain stocks to hedge longer positions in other stocks. If the industry experiences a decline, a profit from a short sale could reduce the effects of the decline on your portfolio as a whole.

Short selling can also be used to extend a trade after the option expires. If you have naked calls that are about to expire, yet you still believe the stock will decline, you can let your original calls expire and deliver the said shares. This practice prevents you from having to repurchase your calls and write more in a market that you believe will fail.

When Is It a Good Time to Short?

Short selling is a risky practice, so it’s imperative to be aware of your timing. When you first discover indicators that a stock is declining, it’s a good time to short. A long history of success can often mean that a decline is on the horizon, so be sure to research the average return of your stock. If the stock has been more successful than average recently, it would be smart to anticipate a decline.

Other indicators of coming troubles may include excessive valuations, the inverted yield curve, complacency in the market as a whole, and declining credit quality. Any of these factors gives reason for you to evaluate your positions and consider shorting.

When short selling, you must be aware of the risks involved. A few cons of short selling include:

· Short squeeze

· Margin account required

· Margin interest incurred

· Potentially unlimited losses

However, while the cons can be significant, the pros can be just as big. If done well, short selling is beneficial because of:

· Hedging against other holdings

· Little initial capital needed

· Leveraged investments possible

· Potential for high profits

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