Can we short sell a trading option stock

Short sale

What are short sales?

On the stock exchange you can sell securities that are not in the portfolio. In English short sale means short sale or short selling. Securities, currencies and derivatives such as options, futures and commodities can be used to sell short. For example, a short seller borrows shares from funds in order to return them to the lender on an agreed date. He speculates that the shares will have fallen in price on the stock market by then. So he can buy them at a cheaper price than he sold them. His profit is the difference between the agreed selling price and the price actually paid for the share.

How do short sales work?

The short sale can take place on the cash market as well as by means of futures. Cash means immediately or within a very short period of time; two to three business days are common. In the case of cash transactions, the short seller must return the securities to the lender within this short period of time.

In the case of a forward transaction, the paper sold does not have to be delivered until a point further in the future. The short seller can choose to purchase the traded security and deliver it when the futures contract expires, or to close out his position before the futures contract expires. He concludes an exactly opposite deal, that is, he buys the security that he previously sold short.

What are the advantages and disadvantages?

There are several goals that can be pursued with short selling. The majority of these are used to speculate on falling prices in the markets. Mainly institutional investors also use short selling to generate arbitrage proceeds between the cash and futures markets by taking advantage of their price differences. If a security can be sold at a higher price on the futures market, the short seller will cover himself at the lower spot rate. Last but not least, individual positions or entire custody accounts can be hedged using short selling by combining purchases with short sales of the same or similar financial instruments. For hedge funds, speculation on falling prices or hedging strategies are part of the business model in order to achieve maximum profits.

Market participants can achieve exceptionally high returns by selling short. However, that means one shouldn't ignore the risks. If the bet on falling security prices does not work out, the short seller is forced to buy the security at a higher price in order to meet his delivery obligation. The loss potential can be unlimited. In extreme cases, it is not possible to acquire the financial instrument on the market on time due to liquidity problems or regulations. Then the buyer of the security can withdraw from the forward transaction and demand compensation from the short seller. The loan fee and transaction costs, as well as interest on the loaned assets, reduce the return on the short sale.

What do investors have to consider when selling short?

If the short seller borrows the paper from other market participants, it is a covered short sale. In the case of uncovered short sales, the investor neither owns the paper nor borrows it, so that the risk of loss increases indefinitely, contrary to the seller's expectations, due to the failure of the business or price movements. Since this can also have a decisive influence on the prices on the markets, uncovered short sales are very controversial. The uncovered short selling of certain securities was temporarily prohibited in Germany in the wake of the last major financial crisis. The EU regulation for uncovered short sales has been in effect since November 1st, 2012, which includes bans on such transactions in stocks, public bonds and credit default insurance on these as well as transparency rules. However, short sales are not to be condemned per se, as they contribute to the liquidity of the markets and can minimize risks in portfolios. Short sales become questionable, however, if they are guided by interests that contradict or even harm those of other market participants. For example, dubious investors put misinformation into circulation in the context of short sales in order to depress security prices. Investment funds, for example, lend shares to hedge funds, which are betting on falling prices, even though fund buyers are hoping for prices to rise.

Conclusion

Short selling makes it possible to earn on falling prices. However, short selling depends on the securities available, their liquidity and price development. Retail investors should not underestimate the risks. Not only can they lead to a total loss of the capital invested, they can go far beyond this if the prices of the financial instruments rise instead of falling as expected. If it is not possible to obtain the selected value at a lower price as planned, the short seller may have to bear excessive prices or pay the buyer compensation. Short selling is useful as protection for accrued profits or for portfolios that are to be hedged against price drops.


Summary:

  • Short sales are carried out with stocks, currencies, derivatives or goods on the spot and futures market
  • Short sellers benefit from falling prices
  • The investor sells securities that are not in his possession at this point in time in order to acquire the financial instruments later at a lower price than the agreed sales price
  • These are covered by lending and repurchase agreements as well as derivatives, for example call options or equal-day settlement; uncovered short sales are largely prohibited in the EU
  • For example, stocks are borrowed from funds; Profit for the short seller results from the difference between the agreed selling price and the purchase price of the returned shares, less lending fees
  • Objectives: Realize profits due to falling markets; Depot and position hedging; Exploitation of exchange rate differences between the cash and futures markets
  • Delivery obligations must be adhered to, trading participants must therefore obtain their papers at all costs; this can lead to high losses or damages if no papers are available

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