Short Selling Stocks: What Is Short Selling And How Does It Work?

Zalim
October 5, 2021
We are introducing one of the most popular trading strategies: short selling. First, we find out what the strategy of the short selling stocks is.
short-selling-stocks

You have a wide range of trading strategies to discover when it comes to getting started with trading or improving your own trading strategies. We are introducing one of the most popular trading strategies: short selling. First, we find out what the short selling stocks strategy is.

We take a look at the risks involved in this trading strategy and the many possibilities. Like so many other trading strategies, short selling is about making profitable use of the constant movements in the market.

Oftentimes, traders focus on making a profit by entering at low prices. Always with the hope that prices will rise at a later point in time and that the digital asset can then be sold at a profit.

It looks different with short selling. This is about the sale of underlying assets that the trader does not even own. A daring sounding approach, but one that is extremely popular with many traders. We’ll find out why.

Table of Contents

What is short selling and how does it work? Explanation & definition simply explained:

Short selling is the sale of underlying assets that the trader himself does not own. In order to realize the short sale of the shares , the trader borrows these underlyings from the broker. The loan period is already set in advance. The trader naturally speculates that he will make a profit from these short sales.

When selling short, the difference between the theoretical purchase price and the actual selling price is profitable. Short selling can involve very different financial products. On the one hand, short sales with stocks, foreign exchange, and commodities and derivatives are possible.

Where did the short sales come from?

The origin of short sales lies with the Dutchman Isaac Le Maire. This trader invested around 80,000 guilders in the Dutch East India Company in 1602. In 1609, the company decided not to distribute dividends. This was due to economic constraints due to political changes.

The company was unable to pay dividends for around seven years, after which Le Maire initially sold its shares in the Dutch East India Company. However, Le Maire sold more securities than he actually owned and thus made the first short sell in stock market history known to us.

For Le Maire, overselling securities was a way of making up for the loss of dividends. Short selling was then banned for some time.

In the 1920s, people were grappling with a global economic crisis. During this time, the short sellers were prohibited on the stock exchanges. This ban lasted until 2007. However, the financial crisis the following year gave short sales a very bad image.

Among other things, the short sales are said to have contributed significantly to the worsening of the crisis. Short selling is correspondingly controversial.

With which broker can you make short sales? Our short selling broker comparison:

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Are Short Selling Prohibited?

Are Short Selling Prohibited?

The concept of short selling may sound a bit chaotic to novice traders. And accordingly, the question arises again and again “Are short selling prohibited?” No, the basic form of short selling is not prohibited even if they appear to be a kind of bet on the development of a stock price.

Short selling trading is not a real game. Would you like to ask the question, “ Are short selling prohibited? “To answer exactly, you would have to go through some law books and still not find exactly what you are looking for because the legal situation regarding short sales for private investors is not very clear.

BaFin and the uncovered short sales

If we look at Europe, the European Securities and Markets Authority has the option of prohibiting short selling. This law has been in effect since 2012. Every state has the option of completely banning short sales.

A unique feature concerning the restriction of short sales in Germany is that uncovered short sales are prohibitd . According to Section 30 of the Securities Trading Act (WpHG), the sale of uncovered short sales has been prohibited throughout the European Union since 2012.

To understand why uncovered short selling is prohibited in Germany, let’s take a closer look at the differences between covered and uncovered short sales. In the case of covered short sales, the investor borrows underlying assets for a specified period. Then, the investor sells these papers on the market as profitably as possible and thus receives a profit.

In the event of an uncovered short sale, investors do not borrow the underlying assets. They are also not in possession of this. This form of uncovered short sales can have correspondingly turbulent effects on the price of the underlying asset.

Short Selling Stocks For Individuals: How They Work

Uncovered short sales are restricted by law. So now, let’s see how short covered sales work for retail investors. In short covered sales, the trader borrows shares from a broker and then repurchases them at a predetermined time. This procedure is also called a short position.

The train of thought behind the short sale is that the price increases in the time between the time of the bond and the time of the sale. As is so often the case, the difference between the selling price and the buying price is what makes the profit.

What you should be aware of is that short sales also incur lending fees. These are deducted from the profit. Short sales are possible as spot and forward transactions.

If you look closely, you realise that short sales are about profiting from falling underlying assets. So the goal is to optimise profits, not through rising prices, but rather through falling prices.

In short, selling with private investors, this strategy can be used to hedge your own portfolio or increase profits. A short sale example of large-scale hedging is hedge funds. These use the short sales to hedge the speculation.

A little digression: go short or go long

The term short sale is rarely heard on the stock exchange. Rather, professional traders use the terms go long and go short. When going long, you bet on the rising prices, and when you go short, you bet on the falling prices. Thus, the short sales are part of the short going range.

Short sales and the various financial products

As already indicated, short selling can be applied to a wide variety of financial products. Financial products come into play particularly frequently in the equity business. You can bet on falling prices for all asset classes. This is also called shorting or short selling.

Options, futures, CFDs, leverage certificates or warrants can be shortened on the stock market, while futures on futures exchanges offer to short with foreign exchange. Basically, shorting is about creating an opportunity to benefit from falling prices.

The short sales and the dividends

Another exciting point is the combination of short sales and dividends. You might think that it is a sensible idea to short-sell when the dividends are paid out.

Because theoretically, you could then divert the dividends distributed into your own cash register. However, there is the stipulation that you have to pass the dividends on to the actual owner as a short seller.

What impact the short sales have on the market

What impact the short sales have on the market

The exact influence of short sales on the market is quite controversial. While some professional traders assume that short selling does not affect the market, other experts assume a connection between short selling and price development.

Some experts see short selling as a corrective because they should prevent excessive price increases.

Critics of short sales more often complain that large investors, in particular, have the opportunity to exert an enormous influence on prices. If a major investor is now working with short sales of a certain company, then this major investor is likely to have an increased interest in the course falling into the bottomless.

That would eventually maximize his profits. But, depending on the reach and influence, a false report or negative news about the company could be enough to make the stock sway significantly.

Between return and risk

As with all other forms of trading, there are some risks involved in short selling. Because short selling is one of the speculative securities transactions, after all, the traders here are betting on falling prices. Accordingly, one should inform oneself carefully about the risks before a short sale.

The risks include, for example, a total loss if one miscalculates and the prices do not develop as desired. This mainly happens when prices rise excessively. Thus, the factors for the development of the course are actually not in the hands of private investors.

What also needs to be considered is that traders also have to pay fees for short sales. First, it is a coming interest on the borrowed underlying assets to the trader to, secondly, the fees for the broker itself. To draw an actual profit on a short sell, you have the difference between the purchase price and the selling price higher than the costs.

Conclusion

Short Selling Stocks conclusion

Short selling is about betting on falling prices. And not by waiting as a trader for prices to drop to stock up on a digital asset. Instead, traders borrow digital assets that are doing well, for example, shortly after a downward trend has become apparent from a broker or an exchange.

If the prices then actually fall, the trader buys the digital asset at a low price. The difference between the first purchase price and the second purchase price is the profit – of course, minus the fees. Not all brokers offer short selling.

So if you should consider dedicating yourself to this trading area, you should inform yourself carefully. There are also big differences when it comes to the pricing of the various providers.

This trading strategy carries some risks that you should always keep in mind. Because only those who have dealt extensively with the many possibilities also have a realistic chance of generating profits here. Short selling is one of the riskiest ways to operate on the stock market. Accordingly, you should bring sufficient financial backing for any unexpected events.

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FAQs

Short selling is also known as short selling, although strictly speaking, it is not the same thing. To reali,se the sale, the trader borrows underlying assets from the broker without actually owning them. Then he sells them to buy them again later at a lower price and give them back to the broker.

In principle, short sales are not prohibited. However, there is now an abundance of legal restrictions in SouthAfrica. It was stipulated that, for example, capital investment companies are not allowed to carry out short sales.

Options, futures, CFDs, leverage certificates or warrants can be shortened on the stock market. In addition, short sales are prevalent in the Forex market.

That is controversial. Some experts see short selling as corrective because it prevents prices from going too high. Others criticise the colossal impact that short selling can have on the market.

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