Today, you’ll learn who loses in short selling.
- What is Short Selling
- Short Selling Example
- Why Would A Broker Lend A Stock
- Short Sellers Loses The Most
The people who loses in short selling are the short sellers.
Short sellers have to pay commission and interest when they borrow shares from their broker.
The broker can lend shares to traders from their inventory and receive the income.
Its inventory is from the long positions of their clients in which they can replace it anytime..
The clients or investors do not benefit from lending their shares because of the agreement when clients sign-up. (source)
When clients sign-up they are required to agree that their long positions can be borrowed without any benefit.
The benefit is actually given to the broker due to the risk.
However, the risk is greater for the short sellers because it can be unlimited.
It is unlimited if the borrowed shares were made on margin.
Margin trading can incur interests and commissions payable to the broker.
The broker actually benefits the most because they can replace the borrowed shares from their other clients.
What is Short Selling
Short selling of stocks involves selling borrowed shares. (source)
Then, borrowed shares are paid back at a lower or higher price, depending upon the market direction.
If the price is lower than the sale price, short sellers make money.
However, short sellers will lose money if the price go up after the sale.
They lose money because they need to pay back their broker at a higher price.
Most of the time, payments to brokers include commissions and interests aside from the increase in stock prices.
Interest is incurred due to clients’ use of margin accounts.
Trading on margin means the cash account is not enough to short sell a stock.
Because it is not enough traders have to borrow from their broker.
The broker is going to lend their investors shares for short sell because the risk is low.
Risk is low because if the stock goes down, their investor’s stocks also go down.
Because the stocks of their investors also go down, they do not lose any money.
Money is actually earned because short sellers pay commissions, spread, and interest.
Later, let us discuss why would a broker lend a stock.
Short Selling Example
According to the video, short selling is a risky type of trading.
It is risky because the trader is betting against a company.
Betting against a company means traders are expecting the stock to go down.
Because of the expectation, traders will borrow from their broker to short the stock.
The broker will then look at their shares in their inventory, clients’ portfolios, and other brokers.
If shares are available, short sellers can borrow the shares for short sales, hoping that the price will go down.
If the share price goes down, the sellers make money while the broker earned a small fee.
However, if the price goes up the short seller will lose unlimited money.
To prevent unlimited losses, traders can put a stop lost order to protect their trading account.
Protecting the trading account is important to live another trading day.
Why Would A Broker Lend A Stock
Short sellers’ losses can be unlimited and brokers are always going to make money from it.
Making money is easy whether the share price goes down or up because the shares are lent from their inventory, clients’ long positions, or other brokers.
However, the inventory can go down as the traders realize that the stock is going down.
When traders realize that the stock is going down, more and more traders will short the stock.
As more traders short the stock, the broker’s inventory is going to go down which makes borrowing shares even harder.
It is going to be harder because there will be fewer available long positions to lend.
The fewer shares available, the short-sellers are susceptible to short squeezes.
Generally, in short squeezes, the broker makes more money because the potential gain is unlimited.
It is unlimited because short sellers are operating in margin.
Operating in margin means they are shorting the stocks by taking a loan.
Short Sellers Loses The Most
Short sellers lose the most because brokers make money even if the stocks go down.
Brokers make money because they are lending their client’s long positions for short.
They can lend because it is written on the agreement when people open a trading account.
In the agreement, there is usually a clause which may say that the broker can let short sellers borrow the investors positions for short selling.
Investors are the ones buying the stocks which are considered to be the inventory of the broker.
The broker may also borrow from other brokers to address the needs of short sellers.
Either way, brokers usually make money even when the stock goes down, while short sellers lose money when the stock goes up.
Shorting stocks maybe risky for stock traders because the losses are unlimited.
It is unlimited because the traders are trading in a margin account or borrowed money.
A margin account is needed to be able to short in the stock market.
In the stock market, the brokers have the advantage over short sellers.
There are advantages because they do not lose money even if the stock price goes down.
Instead of losing money, brokers can drive the price up to squeeze short sellers.
Short squeeze occurs when the stock is usually heavily shorted.