Shorting

[jay2k]

Hi i have searched around the forums and knowledge base trying to find an explanation of shorting i dont understand how it works could someone please explain thanks!

 

[dcraig1]

Hi i have searched around the forums and knowledge base trying to find an explanation of shorting i dont understand how it works could someone please explain thanks!

Suppose a stock is trading at $10. You think it will go down but don't own any. You borrow some and sell them at $10. It drops to $9. You buy the number of shares you borrowed, return them to the lender (Known as covering). You pocket $1 per share.

All this borrowing and covering happens transparently via your broker. All you see is a position of eg -100 shares if you are short as compared to 100 shares if you were long.

 

[Over the Top]

To expand on the response from dcraig1 - when you go Long, you BUY and then SELL to close. When you short a stock (not all stocks can be shorted), you SELL then BUY to close. In both situations you close your open position by effectively taking an opposite position of equal size.

 

[jay2k]

but how is it that you gain from a loss, because if your borrowing that money aren't you losing it when the share price goes down.

 

[dcraig1]

but how is it that you gain from a loss, because if your borrowing that money aren't you losing it when the share price goes down.

You don't own any shares, except momentarily. You've borrowed shares and immediately sold them, then some time later bought them and immediately give them back to the lender.

eg Sell 100 shares @ $10.00 - receive $1000 from the buyer
Buy 100 shares @ $9.00 - pay $900 to the seller

You are $100 better off.

 

[Over the Top]

Forget the borrowing.

Long. BUY at $20. Sell at $25. Profit $5.
Long. BUY at $20. Sell at $15. Loss $5.

Short. SELL at $20. BUY at $15. Profit $5.
Short. SELL at $20. BUY at $25. Loss $5.

If you think the stock, currency, index, commodity is going to decrease in value, then you short it - SELL now and BUY back (to cover) more cheaply later.

If you think it's going to increase in value BUY now and SELL at a higher price later.

That's the theory. In practise it doesn't always work out that way.

 

[jay2k]

thanks everyone for the comments they were very helpful.

 

[Directional]

Same principle in futures except you dont need to borrow anything to short a futures contract.

 

[cwang]

thanks everyone for the comments they were very helpful.

DO NOT short until you fully understand it. shorting is a dangerous thing to do, even with stop loss.

an alternative is to buy put option, which is a lot of safer, but you are paying for volatility and time.

these are concepts to be found on all trading books, i recommend to read one before making your first trade. For books, do NOT buy any book starts with something like "I have become financially independ after discovering this trading strategy, now you can do the same, yada yada" make sure the book look academic.

 

[timsk]

DO NOT short until you fully understand it. shorting is a dangerous thing to do, even with stop loss.
an alternative is to buy put option, which is a lot of safer, but you are paying for volatility and time.

Hi cwang,
The principle of not embarking on a course of action until you understand it fully is sound advice, IMO. However, to imply that instigating a short position is in some way more dangerous than a long position puzzles me. Trading long or short is a dangerous activity if you don't know what you're doing. Given that most instruments have a general propensity to fall faster and further than they rise, some folks would argue that, if anything, going short the market is marginally safer than going long.

To recommend trading options as a safer alternative to shorting, strikes me as being a highly questionable piece of advice. F.H. "Chick" Goslin in his celebrated book 'Trading Day by Day' writes: "Options are one of the greatest and most costly frauds perpetrated on the trading public. [They] have limited risk for the buyer and unlimited risk for the seller. Therefore, it is only natural that individual speculators tend overwhelmingly to buy rather than sell them. Unfortunately for the individual trader, the buy side of options has a significant built-in disadvantage. The very nature of options, as currently set up, is such that the odds are inherently stacked against the buyer (primarily small speculators) and in favour of the seller (usually big, institutional money)".
Tim.

 

[tomorton]

Hi jay2k -

In theory, shorting is not just higher risk than going long, it is the ultimate risk. Putting 1000 shekels in shares, which drop to zero, loses you 5000 shekels. Thoughs share prices cannot drop below zero, they can rise without limit, so going short to the same value can lose you the 5000 shekels plus everything you own.

But this is theory - none of us reading this board should ever open a position without two exit strategies - for if things go well and for if things go badly - it would be like taking off in a plane and just heading off randomly, hoping to spot an airport.

 

[Racer]

Hi cwang,
The principle of not embarking on a course of action until you understand it fully is sound advice, IMO. However, to imply that instigating a short position is in some way more dangerous than a long position puzzles me. Trading long or short is a dangerous activity if you don't know what you're doing. Given that most instruments have a general propensity to fall faster and further than they rise, some folks would argue that, if anything, going short the market is marginally safer than going long.

Tim.

Going short if far preferable for me
Shares/indices tend to fall very fast when they actually decided to go down.. but you have to be patient sometimes and wait for the right time.
Shorting is no different from going long apart from the comments made previously, understand it and then use it as part of your overall strategy if you wish.
If you can go short and long then you can see both sides more easily

 

[cwang]

Hi cwang,
The principle of not embarking on a course of action until you understand it fully is sound advice, IMO. However, to imply that instigating a short position is in some way more dangerous than a long position puzzles me. Trading long or short is a dangerous activity if you don't know what you're doing. Given that most instruments have a general propensity to fall faster and further than they rise, some folks would argue that, if anything, going short the market is marginally safer than going long.

To recommend trading options as a safer alternative to shorting, strikes me as being a highly questionable piece of advice. F.H. "Chick" Goslin in his celebrated book 'Trading Day by Day' writes: "Options are one of the greatest and most costly frauds perpetrated on the trading public. [They] have limited risk for the buyer and unlimited risk for the seller. Therefore, it is only natural that individual speculators tend overwhelmingly to buy rather than sell them. Unfortunately for the individual trader, the buy side of options has a significant built-in disadvantage. The very nature of options, as currently set up, is such that the odds are inherently stacked against the buyer (primarily small speculators) and in favour of the seller (usually big, institutional money)".
Tim.

Hi Timsk:
I was going by worst case for new trader. New trader often tend to hold a position longer than they should (I myself made the same mistake many years ago too) . For longs, it's certain the worst case would be the company falls apart and stock goes to penny. For shorts, there is no telling what may happen over night.

Another aspect is that long and short make no difference if you trade 10:1 margin, but if you trade 2:1 margin, they would make a huge difference, risk wise.

Finally about the option, I was probably wrong to recommend it to him. I am an option trader myself, probably that's why i recommended it
I still want to blubber-mouth a little bit here. I wouldn't go totally negative toward buying option, however. you just need to know what you are buying. If you buy an option, and plan to hold it for more than one hour, then make sure you know the Theta so that you would expect how much value it loses when time passes. Risk is simple with option, buying option in full cash can generate more up/down compare to buying stock with margin. never sell naked options.
Finally if anyone think option is expensive. If you bought s&p put every month with chump change of $100, and let it expire, starting from 10 years ago or even 5 years ago. You would have a big fat return now. (this is just a way to look at it, but please don't do this)

 

[timsk]

Hi Timsk:
For longs, it's certain the worst case would be the company falls apart and stock goes to penny. For shorts, there is no telling what may happen over night.

Hi cwang,
Fair play, I accept your points and those made by tomorton. Between us, I think we have made it clear that whichever 'option' jay2K decides to pursue, it would be wise to exercise extreme caution.


On a general note of going long vs short - I have a question for anyone/everyone. . . Assume you have to make a bet that the instrument(s) you trade will, one day, either double their price in 24 hours or drop to zero in 24 hours. (I realise that the probability of either scenario occurring is very small). But, if you had to make a bet one way or the other - would you go short your instrument(s) or go long? I'd go short every time!
Tim.

 

[cwang]

Hi cwang,
Fair play, I accept your points and those made by tomorton. Between us, I think we have made it clear that whichever 'option' jay2K decides to pursue, it would be wise to exercise extreme caution.


On a general note of going long vs short - I have a question for anyone/everyone. . . Assume you have to make a bet that the instrument(s) you trade will, one day, either double their price in 24 hours or drop to zero in 24 hours. (I realise that the probability of either scenario occurring is very small). But, if you had to make a bet one way or the other - would you go short your instrument(s) or go long? I'd go short every time!
Tim.

If I am very certain, I would define my max risk first, then use all these money to buy equal amount of call option and put option.

If i think the total chance of the above case is small, say, 10%. then I would do the following
x = option price / expected profit
if x < 10%, I buy
if x > 10% I do nothing
(you could plug in a binomial tree instead if you are not buying way-out-of-money options)

I wouldn't trade underlying at all if i think it's either going to 200% or 0, because I could play blackjack instead