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Learning Paper Trading With Trading Simulators - Part 4 –Selling Stock Short (Short Selling)
Overview
In Part 3 we learned about technical analysis, charting and charting indicators. This article will deal with the subject of selling stocks short, or short selling. As usually, you can use your existing account at vivatrader.com to try out all the things we will be talking about.
What exactly is short selling?
I would say, selling stock short requires certain knowledge and discipline. It sounds very attractive and simple, but in reality it is not, at least not when you take into account that this trading technique can magnify your losses significantly.
Short selling simply means selling securities which you do not own. Well, but how can you sell something you do not own? To put long story short, pun is intended, you borrow it. Don't burden yourself with precise mechanics of borrowing you broker will handle this. There are a lot of stock holders that would lend you a stock for short selling. But keep in mind one thing: a borrower can, theoretically, call back shares and force you to close position at a time when you don't want to. So, for this reason, and others, short selling is short term strategy – days and week – do not plan to hold a stock short for month and years.
Who is selling short?
Usually people sell stocks short if they feel that they can profit from it somehow. It might be that one feels strongly that the stock will go down, so it makes sense to sell it now and buy back at the lower price. Yes, since you borrow shares, you have to return shares too, thus profiting the difference.
Let's look at an example:
I shorted (i.e. borrowed and sold on the spot) 100 shares of IBM at $10, thus I deposited 1000 onto my account.
- A few days later the price dropped to $5
- I bought 100 shares of IBM at $5 and returned them to my broker. Since I only spent $500 for this, I pocketed $500 (minus commission).
Are there any risks?
The answer is yes. What if the price moves upward and not downward? Theoretically it can move up significantly, in which case investor can incur steep losses. That is why short selling requires a lot of practicing, and VivaTrader's stock trading simulator is an ideal place to do that.
Let's look at an example:
- I shorted (i.e. borrowed and sold on the spot) 100 shares of IBM at $10, thus I deposited 1000 onto my account.
- A few days later the price went up to $50
- I bought 100 shares of IBM at $50 and returned them to my broker. Since I spent $5000 for this, I lost $4000 (plus commission).
So, let's short some stocks in trading simulator. As before, login to your VivaTrader account, or open a new account using the guidelines from Part One.
Margin Account vs Cash Account
In order to sell stocks short you need to open a margin account, it is a regulatory requirement. Make sure that you select a margin account when you prepare trading order.
Account details before submitting order
Let's take a snapshot of your account details before you execute your order. We will use it to demonstrate some calculations, which are quite important to understand for any trader, willing to sell stocks short. In the example below we have an existing account, which has some holdings.
Date account opened 2010-07-19 00:00:00.0
Initial cash deposit 50000.00
Current NAV 59524.77
Current value of long stock positions 16269.40
Current value of short stock positions 8034.10
Current number of names held long 3
Current number names held short 2
Current Free Cash 39128.22
Current Cash Held as collateral 12161.25
Min collateral required 12161.25
Current loan issued by broker 0.00
Max broker loan allowed 8292.50
Unused loan amount 8292.50
Margin Call Issued No
Creating and Executing Sell Short Order
To create a new sell short order click Order Entry Form or choose Trading -> Trade Securities if you already logged in to your account.
Let's short 100 shares of IBM. To do so, choose IBM for Stock Symbol. After this a chart will appear below the order form, and you perform some technical analysis as described in Part 3. For the purposes of this example, just enter the following information:
- Stock symbol: IBM
- Transaction: Sell Short
- Duration:Day Order
- Quantity: 100
- Price: Market
And click Continue. On the next page you will see a message similar to the following:
The current order price is 145.25. At this price your proceeds from the short selling of 100 shares of IBM will be $14,525.
Including the commission (19.95) the total proceeds will be 14,505.05 .
Click Submit Order. Your order will be executed (actually sometime it might fail, but for the purposes of this article we'll presume it will not). After this let's take a look at our account details again.
Account Details after order execution
You will notice that some numbers change since we took a snapshot of our account before executing a short sell order. Actually, almost all numbers have changed, this happens because the stock trading simulator tracks prices in real time, so it is expected for your portfolio value to fluctuate along with the market.
Initial cash deposit 50000.00
Current NAV 59482.92
Current value of long stock positions 16238.40
Current value of short stock positions 22548.00
Current number of names held long 3
Current number names held short 3
Current Free Cash 34751.38
Current Cash Held as collateral 31041.15
Min collateral required 31041.15
Current loan issued by broker 0.00
Max broker loan allowed 8292.50
Unused loan amount 8292.50
Margin Call Issued No
What is Collateral
We are mostly interested in the Min Collateral Required and Current Cash Held as Collateral metrics. Let's look at these metrics only:
Before execution:
Current Cash Held as collateral 12161.25
Min collateral required 12161.25
After Execution:
Current Cash Held as collateral 31041.15
Min collateral required 31041.15
The collateral is actually the amount of your monies which you cannot use to finance purchase of shares or to withdraw. It is calculated as a percentage of the proceeds of your short sale order, usually at 150%. In our case this security is eligible for reduced margin (we'll talk about it later) so the collateral will be 130% of the proceeds.
Let's break this down, it just looks like something very complicated, there's logic behind it, which every investor that wants to sell short needs to understand:
- Transaction value: $14,523
- Minimal collateral required: $14,523 * 1.3 = $18,879.90. It means we should put aside this amount after the transaction
- Amount we need to finance: $18,879.90 – $14,523 = $4,356.90. We have to have as much cash on our account, or be able to borrow from dealer in order to finance this transaction!
- We had some free cash before the order got executed: $39,128.22. Now you can see that the new amount is $39,128.22 - $4,356.9 = $34,771.32. Factor in the commission and we have the new free cash amount on our account: $34,751.38
- Our collateral before the transaction was $12,161.25, since we need to put aside $18,879.90, our new collateral number is $31,041.15
This could come as a disappointment to some investors, but that is how it works – you cannot use the proceeds from a short sale! Actually you can to a degree – this amount is recalculated daily and some collateral could free up and move into your free cash bucket if the market moves in your direction, meaning the stock goes down. But if not, you should expect to put up more money for collateral, or you can even get a margin call. We will talk about margin calls in next chapter.
Conclusion
In this chapter we learned how to sell stock short and looked at the various accounting details associated with it. I encourage you to enter more sell short orders with various parameters and see what exactly will be happening with each order. Do not forget to check out Account Details before and after each order gets executed. In next article we will talk more about margin calls.
About the Author
Tony is interested in everything related to investment and day trading, and sometime publishes materials pertaining to that area.