The financial market has been extremely turbulent in the past two years. In 2020, under the COVID-19 pandemic, the U.S. stock market circuit breakers and the collapse of crude oil prices are extremely rare events in the financial market in decades. Many investors have withdrawn their funds to avoid risks in the market crash, but at the same time, some investors have won by shorting stocks in the adverse market. What exactly is "shorting"? This article will introduce the operating principles, operation methods and potential risks of short trading.
"Short selling" is also known as short selling. It is an investment term in the financial market. It is a trading model based on the theory of "borrowing and selling first, then buying and returning". When investors expect the market to fall in the future, they can borrow stocks in the market and sell them at the current price first, waiting for the market to fall in the future. When the stock price falls to a certain level, they will buy it back at a lower current price and return it to the borrower. Using this trading model, investors can earn price difference profits in the falling band. In actual transactions, investors can also choose to buy put contracts. If the market falls as expected, they can settle the contract and make a profit.
From the above, we can know that a fall in stock prices is a necessary condition for shorting stocks to make a profit. It is different from the starting point of buying stocks normally: investors look for undervalued stocks to buy at low prices, expecting future stock price increases and then sell at high prices, which is considered "going long"; while "shorting" is just the opposite, it is a strategy of looking for overvalued stocks to sell at high prices first, expecting future stock price drops and then buying back at low prices. It should be noted that investors do not need to buy stocks in advance when choosing to short. If you do not have the corresponding stocks, you can find your own broker to borrow the target stocks. Most brokers can provide this service after verifying your account balance and position status.
"Short selling" means that investors can profit from a falling market. This investment method makes up for the fact that investors could only profit from rising stocks in the past, and it also has another meaning for the development of the financial market.
Short selling has several benefits for financial markets:
Short selling is often used by investors to hedge risks. When the stock market fluctuates greatly or the market outlook is unclear, if investors still have positions, they can hedge market risks through the "short selling" trading model.
When the value of a target stock is overestimated by the market, some institutions will "short sell" it, causing downward pressure on its stock price. This force balances the stock value and prevents it from becoming a bubble.
If profits can only be made by relying on price increases, then investors' profit opportunities will be reduced, and their participation will not be as active as in a market where long and short positions are combined. If there are investment opportunities regardless of whether the market is rising or falling, then market liquidity will also increase accordingly.
"Investment and financial management, there are gains and losses." Since "going long" involves the risk of falling prices, "going short" also involves the risk of rising prices. The risks of shorting are as follows:
The prerequisite for "shorting" is that the price falls. If the price rises instead of falling as expected, investors will face huge losses. In theory, the price can rise endlessly. The profit of "going long" is unlimited, but the loss is limited (the maximum loss is the principal), while the profit of "shorting" is limited, but the loss is unlimited.
Generally speaking, the stocks that investors short sell are borrowed from brokerage firms, so the ownership of the stocks still belongs to the brokerage firms. If the stock price keeps rising, and in the case of such short selling arrangements, the margin in the investor's account is insufficient and has not been paid to the minimum level within the specified time, the brokerage firm has the right to force the account's short position to be closed without informing the investor, that is, to buy back the relevant stocks at the market price.
As a traditional financial instrument, stocks are popular among short-selling investors due to their high volatility. The following will take U.S. stocks as an example to introduce several different methods to short stocks:
First, the target stock is borrowed from a brokerage firm, then sold in the secondary market, and then bought back and returned to the brokerage firm after the stock price drops, and the investor earns the difference.
Here is an example to help readers understand more intuitively:
The so-called short selling of options refers to buying put options and selling call options:
It refers to the right of investors to buy and sell the corresponding stocks at an agreed price at a certain point in the future. If the stock price falls as expected in the future, the investor has the right to sell the stock at a higher price, and the more the stock price falls, the greater the profit; if the price does not fall as expected but rises instead, since the investor is the option holder, he can choose not to exercise the right, and the only loss is the cost of buying the put option.
It means that the investor undertakes the obligation to let the option holder buy the corresponding stock at an agreed price at a certain point in the future. If the stock price falls as expected in the future, the option holder will not exercise the right on the expiration date, and the investor can collect the option premium as profit, but the profit will not increase as the stock price falls more. On the contrary, the investor may suffer unlimited loss due to the continuous rise of the stock price.
If you think the above methods are not suitable for your investment style and you don’t know how to judge a certain stock market, you can consider buying short-selling ETFs. This type of ETF mainly makes profits by shorting stock indexes. For example, in the US stock market, there are "DXD" that shorts the Dow Jones Index and "QID" that shorts the Nasdaq Index. In the futures market, you can actually simply short the stock index and make a profit when the index falls.
CFD is a new financial derivative instrument in the financial market, which supports investors to conduct two-way transactions with a lower entry threshold. This investment method does not involve the ownership of the underlying asset or physical delivery, but simply predicts the future price level and settles the price difference in cash. In CFD transactions, investors can short a single stock or stock index, and can also make profits in a falling market.
All financial products traded on margin carry a high degree of risk to your capital. They are not suited to all investors and you can lose more than your initial deposit. Please ensure that you fully understand the risks involved, and seek independent advice if necessary.