Short Selling Definition
Traders who are short selling a stock are selling shares and creating a negative share balance in their account. This means that when they are holding a short, their position will show them holding -1,000 shares. As soon as they sell the shares, they are bringing in money from the sale. But they must buy back the shares in order to close the position and make a profit. They will need to be bought back at a lower price than what they were sold.
Buying To Covering A Short Position
Take this example: If you sell 1,000 shares of Facebook (FB) at $100.00, you will bring in $100,000. If you cover your short by buying those shares back at $99.00, you only had to spend $99,000 to close that position. This leaves you with $1,000 in profit. The same goes for losses—so if you covered your short position for $101, you would have had to spend $101,000 to cover the position, resulting in a $1,000 loss.
Two reasons why you might want to short a stock are 1. speculation that the price will go down and 2. if you are hedging another position. When you sell shares short, the shares have been borrowed from the broker to sell in advance—so you must have a margin account. Sometimes shares are not available to short because only shares that are held in margin accounts can be used to short against, and if there are not a lot of traders or investors holding that particular stock in margin then it will become hard to borrow.
Understanding Short Interest
An important metric to pay attention to in a stock is the short interest. Short interest is typically displayed as a percentage. When you have a higher percentage of short selling in a stock, it can spark off whats called a short squeeze. This happens when a positive catalyst occurs (like an unexpected business deal or potential buyout news) that attracts a lot of new buyers and starts pushing share prices higher.
As prices go up, shorts will have to start covering their position by buying their shares back, which will then magnify the overall buying in the stock and push shares even higher yet, sometimes in a dramatic fashion. Just like when trading on the long side, it is important to place hard stops so that you can avoid an unexpected move like this. You do not want to be caught on the wrong side of a short squeeze as the losses could be devastating to your account.
Understanding what short selling is and how to execute a short trade is incredibly important as it gives you the ability to play both sides of the market. If you’ve never sold a stock short then you should practice doing it in a simulator until you feel comfortable risking real money.