Short selling: What are the pros and cons?

Short selling: What are the pros and cons?
Table Content
What is short selling?
Why is short selling allowed?
What is the penalty for short selling?
What is short selling in crypto?
How do you know when to short a crypto?
How does short selling hurt a company?
Bottom line

Market players value short selling, a lot. Investors utilize short positions to say a stock is overvalued or to hedge risk. Pension funds, mutual funds, and endowments all generate money by lending stocks to short sellers, and market makers, too, enable stock trading. Some sources say short selling accounts for roughly 50% of listed stock trading volume! So, we should learn more about this. YALLAH!

What is short selling?

Short selling can capture serious profits if it is executed properly. However, traders risk overleveraging the short position and losing all their initial input. In some cases, when you short a stock, its price can keep rising. That means, technically speaking, there's no limit to the amount you'd have to pay to make up for the borrowed shares. 

In finance, "being short" means investing in such a way that you will profit if the investment loses value, e.g., stock or share. You aren't limited to just one way of establishing a short position; there are various ways you can do it. Short selling is essentially a negative (bearish) move, requiring a stock to drop in value for you to make gains. It's a high-risk, interim trading strategy that requires close monitoring of your shares and the market.

For example, a stock is trading at $100 a share. You borrow 200 shares and sell them for $20,000. The price suddenly declines to $50 a share, at which point you purchase 200 shares to replace those you borrowed, netting $10,000. Short selling seems easy when it works, but this brand of speculative trading can place your capital at a huge risk. Today, we'll take a closer look at the specifics of short selling and key information you must understand before entering such a risky position.

Why is short selling allowed?

The market is a mysterious beast; it takes all types of trading and trading strategies to make it tick over so effectively. There are ethical questions that arise from short selling. Arguments have been put across that profiting from somebody else's failure is in bad taste and can discourage economic growth. However, short selling provides a new angle for traders to make money. It opens the possibility of making money during a market downturn instead of just cashing in on a company's stock rising. 

Some governments have briefly suspended short selling to help markets recover during times of extreme volatility, and some have strengthened laws against aggressive methods of short selling. Whilst it remains a controversial way to trade, plenty of economists have argued for the benefits, and ultimately, research has shown it benefits the market as a whole.

What is the penalty for short selling?

Currently, there's no set penalty for short selling. However, some types of short selling are illegal, such as "naked shorting". If you want to maintain a short position, the brokerage with which you have opened the position may impose a margin call. 

A margin call is an instance of when your account drops underneath the maintenance margin amount. A margin call is essentially the brokerage telling you to top up your account or close the position so that you can bring the account back to minimum financial functionality requirements.

Theoretically, $10,000 of shares you purchased with a 50% margin lose 75% of their worth and drop to a valuation of $2,500. This means that the cash balance has fallen to 3/4 of the starting amount, going from $5,000 to $1,250. However, you still owe $5,000 to the brokerage. You need to add liquidity (real cash value) to cover the amount since your shares aren't worth anywhere near what is required to cover the initial loan.

If you fail to do this, your position could be liquidated, and you may be forced to sell, resulting in a complete loss of all of your investment.

What is short selling in crypto?

Despite cryptocurrency being one of the newest types of investment in today's society, if you're looking to short-sell, it works the same way as shorting a stock. One key difference that many cryptocurrency traders have learned the hard way is that it can be a risky road to navigate due to the market's extreme volatility.

The available liquidity may vary depending on the type of exchange you use. So even if you open an effective short position, you may not be able to cash the returns effectively. This was the case when LUNA crashed 99.9% in 48 hours. As the token became worthless due to huge market sell-offs, short-selling positions on certain exchanges were suspended due to the catastrophic drops. All short markets were then quickly suspended, and any future short positions as the token raced to $0.0001 in value.

How do you know when to short a crypto?

There are plenty of market indicators you can look for when shorting a cryptocurrency. Usually, if there's a negative market outlook for the bigger stock exchanges, this will sometimes bleed into cryptocurrency markets. If there is talk of further regulation by governments, this also negatively affects the market. 

Other mitigating factors can play a part, too. For example, Elon Musk was fueling a Dogecoin frenzy back in 2021. He would regularly tweet about the token, sending it soaring 25% to 30% in several hours. Let's say that you knew when Elon was going to tweet next, but the tweet was going to be about how worthless Dogecoin is. This would have been an ideal opportunity short selling the token, as the price would correct dramatically. 

Usually, in times of growth, any retraction or crash is fueled by many factors that are very difficult to predict. However, some people make a lot of money studying the news and charts and taking calculated risks.

How does short selling hurt a company?

Short selling primarily damages a company as it is a bet on whether it will fail. If a large hedge fund, for instance, opens a considerable short position, they are investing in the idea that the company is heading into dangerous territory and may go bust. 

However, there have been instances where short selling has backfired, the most notable of which was the GameStop short squeeze in early 2021. Some large investment funds opened huge short positions on GameStop, but a viral push to purchase their shares began on Reddit and caused the price to rocket. Several investment funds lost hundreds of millions of dollars due to this.

Bottom line

Once again, a major flaw of short selling is the possibility of incurring limitless losses. Typically, margin is used while shorting, and you must pay interest on margin loans for as long as the short position remains open. So, really, it's up to you if you take this path - all we can say is, keep your head on your shoulders at all times.

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