The ultimate goal in the buying and selling of stocks is to make money from them when the trend rises. But what would happen if the trend reverses to a decline? How could investors make money from this phenomenon? In this article, we would talk about short selling and how it works.
What is short selling?
Short selling is a trading strategy wherein traders seek to make money from the belief that a stock will decline. It is the sale of a security that is not currently owned by the seller, or more simply put, borrowed from a broker. It aims to immediately sell the stocks at their current price, then bought back or covered at a lower price to make profit.
Short selling is led either by the speculation that the market will decline or by the desire to hedge the downside risk of a long position. There is a misconception that short selling is done with the intention to put companies into bankruptcy. The truth, however, is the other way around. Short selling actually facilitates smooth functioning of the markets by providing liquidity, it also acts as a restraining influence to avoid overvalued stocks and assist in stock value correction.
How do you short sell?
Long term investments usually follow the conventional principle of buying low and selling high. It is also the same as with short selling, with just a minor difference. It initializes selling high first, and then waits to buy at a lower price. The short seller then generates profit from the difference on the price when the stocks are sold and when they are bought back.
Let us consider the following example:
A trader speculates that stock ABC would decline in value. It is currently priced at $20. The trader decides to borrow 1000 stocks from his broker, who in turn looks for stock sources – either from his own inventory, a client’s portfolio, or from other brokers. The stocks he borrowed are then immediately sold at their current price and the proceeds will be transferred to the trader’s account amounting to $20,000.
After a week, stock ABC falls to $15. The trader decides to close the short position and buys 1,000 shares of ABC at $15 each on the open market in order to replace the stocks he had borrowed. To sum it up, the trader has made a profit of $5,000 from that transaction, excluding the commissions and interest that he owes the broker.
Now, what if the trader’s speculation did not happen and the stock price increased instead? Let’s take for example that after a week, stock ABC shot up to $30 each. It so happens that the original owner of the stocks has demanded his shares back. The broker has no choice but to close the position of the trader. The trader’s loss has now amounted to $10,000 (($30*1000) -$20,000), excluding the commissions and interest that he still owes the broker.
Risks of short selling
Taking from the example above, we may understand the huge risks of short selling. In a normal investment, the biggest loss that an investor can have is only equivalent to the amount he used to buy his stocks while his biggest gains are theoretically infinite since nobody can tell up to what value the market can rise up to. It is the opposite in short selling, because the biggest gains of a short seller can only be equal to the amount of the stock when sold, while his biggest loss is theoretically infinite – the short seller’s loss is parallel to the market value of the stock as it increases.
Short selling is considered as a very dangerous strategy because of the market’s volatility. No one can really speculate if the trend is going up or down. However, skilled traders and investors find this strategy profitable and practical when done right. Always remember that the best way to beat the market is by establishing enough knowledge and learning the fundamentals so as to avoid being run over by the market’s unpredictable trend.
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