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  • Writer's picturejustinlawrence137

Shorting in a red market (Explained)

Do you know when or why you should short sell? Here is some insight for you!

Short selling - Commonly referred to as shorting, short selling is a technique that can be used to generate profits from a fall in the value of a stock, market, currency or commodity.

So unlike trading long, where the aim is to profit from the share price rising, when trading short your aim is to profit from the stock price falling.

When trading long, the intention is buy low and sell high, whereas when you trade short you want to sell high and buy low. Some people struggle with this concept because it can seem absurd to sell shares you don’t own.

But shorting has its advantages and disadvantages.

Imagine a trader who believes that ABC stock currently trading at $50 will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares. (Which may not always be available if the stock is already heavily shorted by other traders.)

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 - $40 = $10 x 100 shares = $1,000).

So if the market is in the red and continues to decline it is a popular advantage to day traders to continue to short the market when it is red, makes sense right?

Traders just need to be cautious of a few things when shorting and two of those are direction and interest. Interest - when you short your brokerage charges interested on the "borrowed" shares which interest % can very depending on the volatility and situation of the position. If you are caught holding a short for a long period of time you may find yourself with some hefty interest charges. Direction, one thing you need to be cautious of when shorting is direction unlike taking a long position if you buy 1 share for $100 and that share goes to $0. You can only loose what you are invested with, but with shorting you can potentially have unlimited losses.

Still have questions about shorting?

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In addition we also added another video about path dependency which is located in the ETF Section!

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