Short Selling Strategies

Profit
Imagine a trader who believes that XYZ 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 they did not own but had borrowed.

A week later, the company whose shares were shorted reports dismal financial quarterly results, and the stock falls to $40. The trader closes 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, based on the following calculations: $50 - $40 = $10 and $10 x 100 shares = $1,000.

Loss
Using the scenario above, suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars.


If the trader decides to close the short position at $65, the loss on the short sale would be $1,500, based on the following calculations: $50 - $65 = negative $15, and negative $15 × 100 shares = $1,500 loss. In this case, the trader had to buy back the shares at a significantly higher price to cover their position.

Hedge
The primary objective of hedging is protection, as opposed to the profit motivation of speculation. Hedging aims to protect gains or mitigate losses in a portfolio. The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts.

Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue higher. If 50% of a portfolio with a close correlation to the Standard & Poor’s 500 Index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain, or 7.5%.