Short Selling and its Importance in Day Trading

Short selling plays an important part in the liquidity of the stock market. If a stock becomes overvalued according to the market, then short sellers borrow shares to sell the stock down, thereby aligning stock prices to their fair value.

The practice of short selling combines the opinions of both bulls and bears to arrive at an equitable price for stock. Short selling provides other benefits to the market that include greater liquidity, which increases the opportunities for short term traders like scalpers and day traders.

More liquidity also leads to tighter bid/offer spreads that reduce overall costs to active day traders. In addition, shorting stocks increases capital formation and lowers the likelihood of bubbles and crashes due to the increased efficiency and more accurate pricing in the market.

With respect to large investors, fund managers allocate funds efficiently and hedge against long-term investment strategies. In combination with futures and options, shorting stock could be integrated into numerous highly profitable day trading strategies, including arbitrage and momentum trading.

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The ethics of short selling

Shorting is sometimes seen as an attack on the stock market, because certain investors view it as betting on failure rather than wagering on success. If you mention short selling to an investor, you’re likely to get one of two responses:

  • “Short sellers provide a valuable service by keeping stocks from running too high and by exposing frauds.”
  • “Short sellers spread false rumors and sow uncertainty in profitable and socially valuable companies for their own profit.”

It’s a stark dichotomy, and while there’s some gray area, it won’t seem like it if you ask investors who have been on the receiving end of a short seller’s attack. Still, both points can hold true.

Short sellers get a bad rap because “they are viewed as betting against the success of a business, and, to many, that is an ‘un-American’ attitude,” Johnson says. “Since short sellers succeed when stock prices decline, they are viewed negatively by many, even seen as nefarious.”

Yet, short selling can limit the rise of stocks, and prevent them from running into a speculative frenzy, helping the market maintain order. Shorts may also bring to light valuable information about companies that are undertaking fraudulent activity or accounting shenanigans, so that investors as a whole have more complete information and may properly price a company.

And short sellers bring another positive to the market, too, Johnson says. “The most important value of short selling is that it provides markets with a greater degree of liquidity. More investors stand ready to buy and sell,” he says.

On the other hand, some very public short sellers are happy to spread rumors or opinions that try to discredit profitable companies and scare the market into selling them. This practice hurts the company’s shareholders, causing their stock to trade below where it otherwise would trade. The short seller can then profit on the fear or doubt and book a profitable short sale.

A simple example of a short-selling transaction

Here’s how short selling can work in practice: Say you’ve identified a stock that currently trades at $100 per share. You think that stock is overvalued, and you believe that its price is likely to fall in the near future. Accordingly, you decide that you want to sell 100 shares of the stock short. You follow the process described in the previous section and initiate a short position. 

When you sell the stock short, you’ll receive $10,000 in cash proceeds, less whatever your broker charges you as a commission. That money will be credited to your account in the same manner as any other stock sale, but you’ll also have a debt obligation to repay the borrowed shares at some time in the future.

Now let’s say that the stock falls to $70 per share. Now you can close the short position by buying 100 shares at $70 each, which will cost you $7,000. You collected $10,000 when you initiated the position, so you’re left with $3,000. That represents your profit — again, minus any transaction costs that your broker charged you in conjunction with the sale and purchase of the shares.

Be careful with short selling

Short selling can be a lucrative way to profit if a stock drops in value, but it comes with big risk and should be attempted only by experienced investors. And even then, it should be used sparingly and only after a careful assessment of the risks involved. 

Expert Q&A

The Motley Fool had a chance to connect with an expert on shorting: Sofia Johan, an associate professor in the finance department of FAU’s College of Business.

Sofia Johan, associate professor in the finance de

Sofia Johan, associate professor in the finance department of FAU’s College of Business. Her areas of expertise and research interest include legal and ethical issues in financial markets, entrepreneurial finance, and regulation of financial markets around the world.

The Motley Fool: Short selling can be risky, but also lucrative. What are the top benefits and risks to consider when shorting a stock?

Johan: The risk/reward trade-off isn’t new to any investor, but in short selling I find lack of understanding of the risks. The benefit is simple. As an investor, you are not only able to profit by purchasing shares when prices are rising, but also when prices are falling. It isn’t a new strategy for more sophisticated investors, but I think unfortunately recent events have highlighted the beauty of short selling to retail investors. I read somewhere recently that up to a quarter of the trading volume in the U.S. equity markets is short positions. The benefits of shorting the market, if done well, do not only apply to investors. Yes, you are, as an investor, “profiting from misery,” but you also are providing liquidity to the market. Short positions make pricing easier for market participants, thus potentially preventing other investors from overpaying. The risk is that many investors do not necessarily understand how the market works, for example how market manipulation can exacerbate risk.

Frequently Asked Questions

Q

A The risk of short selling is the stock price goes up and you must cover the position at a higher price (taking a loss).

Q A Brokers serve as a middleman that allows you to borrow shares and they charge you interest.

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