Short selling is a trading process which attempts to profit from share depreciation. Typically, you earn profit from share appreciation, which involves buying share at a low price, holding the share until it reaches a substantially higher price, and then selling the share. Short sales operate in reverse. Short Sellers borrow shares from their broker and sell the shares at a high price. Short sellers watch the value of shares decrease, then buy the shares at a lower price and return them to the broker. The difference between the high sale and the lower buy equal the short seller’s profit, before any fees or commissions paid.
Shares are never owned by short sellers; they are loaned to short sellers from the accounts of their investors. This results in short positioners gaining none of the share ownership advantages. Short sellers are not entitled to dividends or extra shares from share splits. Any income gained from shares other than share depreciation must be surrendered to the brokerage. Short position holders cannot exercise voting powers or appoint board members; they cannot control the firm in any way.
A short sale is initiated by loaning of shares, which means that the entire process is essentially leveraged. Short sellers are almost always required to post an amount of collateral in case the loan goes badly. You typically will be forced to post at least 50% of the value of the shares for collateral. If the collateral amount posted declines, which it will if the share appreciates instead of decreasing in price, you will be required to post more collateral. This is known as a margin call. If the margin call isn’t posted, the broker may forcibly recall some or all of the shares. If all shares are recalled the short ends.
The share’s real owner may need to utilize the shares for voting or appointments. Since the broker loans shares to you, the brokerage can recall the shares and return them to their owners if needed for controlling concerns. The availability of shares for short selling ultimately depends on the owners, and shareholders may even get lending fees for allowing short selling transactions.
Short selling is inherently riskier than typical “buy-low, sell-high” approach to profits from share appreciation. In typical investment, losses are limited by hitting zero. You cannot lose greater than the value of your investment when you purchase shares. However, in a short sale money is lost if the short is closed out or recalled when prices are higher than when the short was initiated. Shares can technically increase infinitely in price, as long as demand exists to justify the price.
Shorting shares during bull markets is especially dangerous, since share prices can easily increase substantially in short periods of time. The biggest risk of this occurring is if another firm is attempting to make an acquisition of the short seller’s target during the short. If a buyer steps in and offers shareholders a premium, the share will have large amounts of purchases attempting to earn the premium. This will result in a large price jump with many buyers of shares. A liquidity problem can occur, where there are more share buyers than there are sellers of shares. In theory, a situation could occur where you cannot close your short sale while prices are rising, suffering heavy losses. This becomes more likely the lower the firm’s market capitalization.
Micro or small capitalizations can trap short sellers in situations where prices are rising and they cannot close their short. These firms typically have lower amounts of shares on the market. If a micro or small capitalization firm become popular during a short sale, you may suddenly find that there are not enough shares available to close a short.
The last theoretical liquidity problem can occur if a firm is targeted by a large amount of short sellers simultaneously. If shorts are being closed in rapid succession on small or micro capitalizations, the constant purchases will place upward pressure on market values. Traders may find themselves unable to locate shares at a desirable price. Some exchanges require short sellers to report their trading positions, allowing liquidity issue anticipation.
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