Short-selling
Short-selling is a method of profiting from stocks that are dropping in value (also known as “going short” or “shorting”). In theory, short selling appears to be a straightforward concept: an investor borrows a stock, sells it, and then buys it back to return it to the lender. However, it is a sophisticated approach that seasoned investors and traders should only use.
Short-sellers bet on the price of the stock they are short-selling falling. If the stock falls in value after the short seller sells it, they buy it back at a lower price and return it to the lender. The short seller’s profit is the difference between the sell and buy prices.
Assume that an investor believes ABC is overvalued at $200 per share and that the stock will fall in value. In that situation, the investor may “borrow” 10 ABC shares from their broker and subsequently sell them for $200 on the open market. If the stock drops to $125, the investor can repurchase the 10 shares at that price, return the borrowed shares to their broker, and make a profit of $750 ($2,000 – $1,250). If the price of ABC stock climbs to $250, however, the investor will lose $500 ($2,000 – $2,500).
What Are the Consequences?
Short selling dramatically increases the risk. When investors buy a stock (or go long), they are only risking their initial investment. As a result, if an investor purchased one ABC share for $200, the most they can lose is $200 because the price cannot fall below $0. Put another way, the lowest a stock can go is $0.
On the other hand, short-sellers can theoretically lose an endless amount of money because a stock’s price can rise indefinitely. If an investor had a short position in ABC and the price rose to $375 before they exited, they would lose $175 per share.
Short squeeze
A “short squeeze,” in which a stock with a substantial short interest (i.e., a stock that has been heavily sold short) rapidly rises in price, is another risk faced by short-sellers. As more short sellers purchase back the stock to close off their short positions and cap their losses, the stock’s price rises even faster.
Margined account
If the price of the stock that the trader has sold short suddenly rises (for example, if the company announces in its quarterly report that earnings have exceeded expectations), the trader must immediately deposit additional funds into the margin account, or the brokerage will forcibly close out the short position, leaving the trader with a loss.
When an investor shorts a stock, the amount they can lose is theoretically unlimited because the stock can continue to rise in value eternally. Investors may even end up owing their brokerage money in some situations.
Why Do Traders Sell Short?
Short selling can be used for speculative or hedging purposes. Short selling is a strategy used by speculators to profit from a projected decline in specific securities or the market. Hedgers use the method to safeguard gains or limit losses in a security or portfolio.
Short-selling tactics are commonly used by institutional investors and intelligent individuals for both speculating and hedging purposes. Hedge funds are among the most active short-sellers, and they frequently employ short positions in specific equities or sectors to offset long bets in other securities.
When Is Short Selling a Good Idea?
Short selling is not widespread among investors, believing that equities would appreciate over time. In the long run, the stock market tends to rise, yet bear markets, in which equities fall sharply, occur from time to time.
Buying stocks rather than short selling is a safer bet for the average investor with a long-term investing plan. Short selling may only make sense in certain circumstances, such as during a prolonged bear market or when a company is in financial distress. Sophisticated investors should only attempt short selling with a high-risk tolerance and a thorough understanding of the dangers involved.
Can you lose more money in a short sale than you put in?
Yes, you can lose a lot more money in a short sale than you put in; in theory, your losses are limitless. This is the polar opposite of a traditional “long” approach, in which the maximum gain on a stock you’ve purchased is theoretically infinite. Still, the most you can lose is your initial investment.
Important points to remember
Short-sellers bet that the price of a stock will fall.
Short selling is riskier than buying a stock long because the amount you can lose is theoretically unlimited.
Because equities tend to lose value quicker than they appreciate, short selling can provide a decent profit in the near term if done correctly.
Short selling stocks may not be advantageous for inexperienced investors.
