This article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).
Ipek Ozkardeskaya, LCG
Short selling is the sale of a security that is not owned by the seller. A short-seller borrows the stock to sell with a promise to deliver the security back to the original owner at some time in the future. This means that selling short a stock implies a buy back in the future for restitution.
Brokerage companies are most commonly used as lenders, that play the role of intermediary between the investors and the short-sellers in exchange of a fee.
Somewhat a contradictory view of an investment, short-selling is a way to generate return on poorly performing security.
The motivation behind short selling is either to speculate on the decline of a security’s price, to build a trading strategy or to hedge the downside risks of an existing long position.
Derivative strategies could be an example of such need to sell short a security.
In practice…
Back in the day, short selling was mostly at financial institutions, hedge funds and a handful of individual traders’ disposal.
Today, a fast growing industry of brokers offers the short-selling possibility to a vast pallet of investors and at very competitive prices.
A margin account with LCG allows an investor to borrow cash in exchange of the initial investment as collateral. The online brokerage firms give the opportunity to short sell a stock via a single click. ‘Short sell’ or ‘sell to cover’ are the most commonly used wording on a trading platform.
As the investor places a short sell order, the brokerage firm borrows the shares from its own inventory, on the margin account of one of its clients or from another broker and sells the borrowed shares in the market. The proceeds from the sale of shares are then credited on the investor’s account. The profit and loss is calculated on the differential of the sale price and the market price.
Given that the stock price cannot slip below zero, the gains are limited. The risk of loss, however, is unlimited. While selling short a security, the price of a security can rise infinitely. Therefore, only experienced traders are recommended to sell short.
Short selling is not a long-term strategy, given that companies are here to succeed and not to fail. Stocks are naturally expected to gain in value over time. Selling a stock is mostly swimming against the flow and is therefore risky play.