If you are interested in trading, you may have heard about short positions, short selling, or terms that include short. A short position happens when you anticipate a decline in a company’s price. It is the contrast of investing where you purchase because you believe that the price will grow in the long run.
Traders need to know how a short position works and why other traders use it. It can be a great strategy if you know well how they work and understand how a market behaves.
Let us define a short position.
In short positions, a trader borrows shares from another investor with the intention of selling them to another investor. Later on, you return the borrowed shares to the original owner by buying another set of shares. Short-selling means selling shares at a high price, buying new shares, and giving back the borrowed shares at a cheaper price than the price you set when you sold them to another investor. This method is a way of gaining profits from that difference. Short-selling is also applicable to other tradable assets like forex, securities, futures, and the like.
A trader should be more knowledgeable and experienced before short-selling because it is not like any other trades. It may not be very clear for some investors who just started trading.
An example scenario with a short position
Ferdinand thinks that X Company’s stocks are overvalued, and he anticipates a price decline in the coming days. He borrows 50 shares of X Company from Y Investment Company. Ferdinand looked for another investor who will buy these 50 shares at $100 per share. After he sold them, he now has $5,000. After a few days, Ferdinand’s predictions were correct because X Company’s stock price declined to $80. Ferdinand now gives back those shares to X Company by purchasing 50 of their shares at $80 per share. Due to Ferdinand’s excellent anticipation and expectations, he now takes home $1,000, excluding any fees incurred like fees from Y Investment Company.
A short position is not that easy as it sounds.
Now, what happens to Ferdinand if X Company’s stock went in a direction he did not anticipate? What if they increased instead of the predicted decrease?
Ferdinand still must return these stocks as promised. Say, one stock increased to $120 each. Now, Ferdinand has to pay $6,000 to replace the 50 shares he borrowed, leaving him with a $1,000 loss. If Ferdinand believes that this increase is just short-term, he could wait and see. However, there is a risk that he might have to pay higher than $120 now, leaving him with more losses if X Company’s stock prices continue to soar. The company can ask Ferdinand to return their stocks anytime, especially if they think their stocks will steadily grow and increase.
This is what we mean when we said that it is not recommended for traders who are just beginning to use a short position unless they are knowledgeable and confident enough to enter a world of risks.