With every market drop you will hear lots of words like short selling, going short or shorting. And many times you can also hear the experts blame short-selling for the drop. This article is a brief description about shorting, ways for that and its effects on different markets.
The best explanation one can give to shorting is that it is opposite of going long. When you go long you buy a financial instrument, can be stock, futures, Forex currencies, EFTs, mutual funds, etc, hold it for a period then sell it. If the selling price is higher than that you bought, then you made a profit; and if it dropped against the buying price then you suffered a loss. Now going short is the opposite process; you first sell the instrument, wait for a time period and buy back the instrument. If the instrument price drops when you buy back then you profit and if it rises against selling price you loss. But there is a problem, how can you sell an instrument if you don’t have it? The answer is short sellers first have to borrow the instrument from others, usually from a broker. This borrowing process can be costly as it usually includes a margin charged by the broker.
As said early, experts are not much favorable to short trading. Many markets and countries have strict regulations on short selling. Many believe that excess shorting can create a negative confidence in the market. The opinion is that when there are many traders hoping for a price drop then the overall market sentiment can drive the price down. And if there is a market crisis, then shorting can add to that crisis and can trigger an even bigger crisis. Regulators of US and most European markets have placed restrictions on naked short selling – selling without actually borrowing the stock within the set timeframe.
Shorting can cause vastly different impacts on contract markets. In trading of contracts like futures, options and currency pairs, usually you don’t find any restrictions. In futures market short selling means your obligation to deliver a commodity at the expiration date of contract; and in options market it means your right not obligation to sell the underlying instrument at a fixed price. In currency trading, the scenario is a whole lot different. There you don’t find any short selling restrictions of any kind. This is because there is actually no real shorting as in stock trading. In a long Forex trade you buy the first currency of a pair using second currency and in short Forex trade you just buy the second currency using first currency; in any way you are buying (going long).
Apart from just profiting from expected price drops, short selling is widely used as hedging and arbitrage tools. Some traders can use it as an ‘against the box’ tool to lock the profit they already made in a long-position, which they want to hold continue.