There are several reasons to short stocks in Canada, but before delving into the reasons, let’s understand what shorting is all about.
Shorting a Stock. All You Need to Know
With stock trading, short selling is a strategy you can use to generate profits even when the market is moving down. This type of trading involves borrowing shares from a broker and then selling them in the market. You can sell short on almost all equity-based securities, including stocks and options, although not all brokers allow short selling on every stock.
The aim is to buy these shares back later at a lower price, return the shares to the broker, and pocket the difference. If a stock’s value falls by more than your cost basis, you pocket the difference. If a stock’s value rises, you have to repurchase it at a price higher than your basis, and you lose the difference.
Short Stocks in Canada. How Do They Work?
To short stock, you must have a non-registered margin account. You will need to apply for this account by submitting a margin account agreement form. Upon approval, you can proceed to other processes. The process of approving this account is similar to that of a loan application since the brokerage company will need to see an assurance that you can pay the borrowed amount.
So, can you short stock in Canada? Yes, the government allows this form of strategy. Here’s a look at how it works.
As an investor, you will borrow some amount in stocks from a brokerage company so that you can trade it in the market. The aim is to take advantage of the fluctuating stock prices to make profits when there are negative fluctuations.
You borrow shares from a lender and then sell on the open market in the process of short selling. A lower price for the borrowed stocks is your goal at this point.
Example of Short Stocks
Smart Example How to Short Stocks
How to Short Stocks in Canada. The Complete Guide
You might borrow 1000 stocks from a broker and sell them at the current market price of $15 per share after deducting all expenses. You will thus sell your stocks at $15,000 and hope to buy them later at a lower price.
Your profit is the difference between the selling price at which you sold the shares and the price at which you had to buy new ones later (you will also need to deduct other expenses like fees or requirements in your margin account).
Using the above example, if your short stock succeeds, you might buy the same stocks at a lower fee of $8 per stock, making your buying price $8,000. Since you had deducted all expenses, you will have $7,000, i.e., the selling price less the buying cost. You will then return the original stock to the lender and enjoy your proceeds.
You may have to close your short position at any moment after shorting the stocks because your brokerage might no longer manage to loan you shares. Forced buy-in is the term for this scenario.
Even though there is no set time limit for replacing your borrowed shares, the lender keeps the right to liquidate your stock positions to minimize losses if you cannot replace the borrowed shares when an adverse price movement occurs.
How to Short Stocks in Canada Without Risks.
While short stocking may be a good investment strategy, it has some risks that every investor needs to know.
There’s Uncertainty with Market Trends
Your short stock selling technique is fundamentally a game of chance and luck. Even well-informed short stock investors will fail to predict the market correctly, let alone do so consistently enough to generate a meaningful profit.
As an example, consider the company GameStop (NYSE: GME). Several short-sellers set their eyes on this failing video game retail shop before it closed its doors in February 2021. For nearly 10 years, GameStop had battled to keep up with a market that increasingly favored digital video games over traditional video games. The company’s stock price had been declining steadily. Although a new group of executives helped to boost stock prices in January, short traders anticipated GameStop shares to drop once more.
And they may have if it weren’t for the WallStreetBets Reddit community. Group members received alerts to the fact that investors were shorting GameStop shares. An unusual strategy that confused nearly all investors, these investors carried out a short squeeze, which meant they purchased stock and pushed the cost of GameStop stock upward. As a result of this, short-sellers started to lose a considerable amount of money at an accelerating rate.
The GameStop situation may appear to be an outlier. However, it demonstrates a significant risk associated with short selling: you have no way of knowing how the market trends will be. When you believe a firm is about to go out of business, an investor group comes in and rekindles the flames. And when you’re on the losing end, your losses can put you in a serious financial bind.
You’re Taking Advantage of Someone Else’s Inventory.
The shares you borrow are not yours, and you are responsible for returning them to the lender. If the broker who loaned you the stocks asks for them back, you must return them to him. Period. As a result, it may force you to close your position before making a profit, meaning you’ll have to accept your losses and buy back their shares from the market.
Typically, when you invest in stocks, there’s the possibility for unlimited profit and restricted losses. Your securities can go to zero, and you’ll forfeit all of your original investment if you’re unlucky enough to lose everything. The only thing you’ll have to think about is how much you can make if your stock values rise.
The converse is true when it comes to short selling. As long as you don’t go over your limit, you’ll be fine.
Let’s inspect your borrowed stocks. For $15 per share, you borrow 1000 shares and sell them. You have $15,000 in your trading account and decide to buy back your shares when they drop in price. Once the stock value reaches zero, you can make the most money. You may make a $15,000 investment in 1,000 shares and walk away with your money.
Assuming that you’re mistaken. The stock company is successful and its share price rises to $20 per share. It means that if you have to return the 1,000 shares of the stock, you’d have to spend $20,000—$15,000 from the original transaction and $5,000 of your money. So, you’d lose $5,000 eventually.
Suppose it wasn’t mandatory to return the stocks at $20 because you didn’t have to. You are still sure the value of the stock will decrease. If the value of the stock continues to rise, your losses will only get worse. You’d lose $10,000 if the stock dropped to $25. You would lose $15,000 if you paid $30. And so forth.
How to Short Stocks in Canada. Pros and Cons
How to Short Stocks. Pros and Cons
How to Short Stocks in Canada. The Complete Guide
Potential advantages of short selling stocks include:
- You could make profits in the short term if and when stock prices fall.
- You could use it to offset other risks in your portfolio.
- Using margin gives you leverage, you don’t have to come up with as much capital for the original investment.
- Short selling can have a good return on investment to hedge if done correctly.
Short-selling stocks have the following disadvantages:
- Has a higher risk.
- Trading costs are higher than standard stock trading (i.e., considering the additional expenses like the stock loan fees, margin interest, etc.).
- Your company may need “forced buy-in.”
- Because there is no limit on how high the cost of the stocks you loaned (and their replacement cost) can go, there is the potential for unlimited loss.
- While short, short-sellers are fully accountable for dividend fees and any other cash flows.
- Some securities cannot be shorted, such as:
- Securities trading for less than $1 (one dollar).
- Pink Sheet Securities and the Nasdaq Bulletin Board
- Securities in the United States that aren’t on the Protected List.
- Securities with a loan value of zero on the credit watch list.
To short stocks in Canada successfully, an investor needs to have the relevant experience to predict market trends and thus make wise decisions. Adequate research is also necessary at every stage to identify the potential stocks to place your investment in. Experience and market research can be critical components in overcoming or avoiding the risks of short stocking.