Course: What is Short Selling in Day Trading?

What is Short Selling in Day Trading?

The first step in short selling is for a day trader to advise their broker that they wish to borrow a certain number of shares in a stock. In most situations, a broker will lend those shares. The day trader will in turn almost immediately sell those shares and then very carefully begin to monitor their screens.

To be successful in short selling, the day trader must purchase back those shares at a lower price than they were sold for. For example, a day trader borrows 500 shares of Apple Inc. (ticker: AAPL) from their broker. They immediately sell them at $173.00 and then purchase them back when the price decreases to $172.50. They return the 500 shares to their broker and earn $250 ($0.50 x 500 shares).

In the alternative, a day trader may borrow 500 shares of AAPL and sell them at $173.00, but instead of the price decreasing, the price will increase. Their broker will still require them to return the shares. That requirement may result in the day trader purchasing them back later that day at $173.50. They will return the 500 shares to their broker but they will have lost $250 ($.50 x 500 shares).

It is important with short selling to always remember that brokers require their shares to be returned to them. It may cost a day trader their entire account, and more, but their broker will still require the return of their shares.

In theory, short selling may present as being simple, but it is not. It is a very complicated process and it requires considerable experience in day trading. As it is very easy to lose money when short selling, beginner traders should first practice short selling in their simulators.

When purchasing the stocks of a company for $5, the worst case scenario is that the company will go bankrupt and the day trader’s loss will be limited to $5 per share. If the day trader is short selling and has sold those stocks at $5 per share and, instead of decreasing, the price increases, their loss will be unlimited. The price may increase to $10, $20, or $100 per share, or possibly more. Their broker will still require that their shares be returned to them. The day trader may lose all of the funds in their account and their broker will sue them for additional funds if they cannot cover their entire loss.

With that warning, short selling is an important part of trading because stock prices usually decrease much more rapidly than they increase. Fear is always a more powerful feeling than greed. Therefore, short sellers, if they trade correctly, can make significant profits while other traders panic and begin to sell off.

A final note. AAPL is used as an example in this article because it is a well-known company. Day traders should not trade AAPL unless it is experiencing a very unusual trading volume. If its trading volume is not higher than normal, it means that its trading is being dominated by institutional traders, and day traders should not trade AAPL on those days.