What is Short Selling?
Short selling is an investing strategy where an investor borrows and sells a stock, only to repurchase them at a lower price. The profit is the difference between the sell and buy price.
Originally published on Zinvest: zvstus.com/blog/what-is-short-selling
Short Selling Defined:
Short selling is a bearish strategy occurring when an investor borrows a security and immediately sells it on the open stock market, planning to buy it back later for less money to profit.
Introduction
When an investor decides to short a stock, they borrow shares from a broker to sell on the open market. The investor is essentially betting against a stock or company and anticipating price drops in future market value.
If correctly predicted and share prices decline, an investor can repurchase the shares at their lower prices. Then, the investor can return the borrowed shares to their broker and profit from the difference. This strategy is known as shorting a stock, selling short, and going short.
What Does It Mean to Short Sell?
The general idea of investing in stocks is to go long, known as holding a long position.
Typically, when a person purchases a stock because they think it will do well, they want to hold onto it until it becomes more valuable — the investor predicts share prices to increase the longer they hold.
For investors going long, they want the company they’re investing in to succeed. If the company does well, its stock prices will increase, and investors will receive higher returns.
Going short would be the opposite, with a short seller, usually an experienced and savvy investor, predicting a company to perform poorly. Investors would be holding short positions in this situation.
Short sellers essentially sell assets they don’t currently hold in their portfolios; this investment strategy allows traders to profit off a stock’s decline.
How Short Selling Works
When holding a short position, a short seller speculates that a company they’re looking into is trending downwards. The investor believes that the stock may be overvalued and might drop in price, allowing for an opportunity to profit.
How to short a stock
For example, an investor expects a business dealing with financial issues to have a declining stock price and market value in the future; to profit off this prediction, the investor will perform a short sale.
The investor will call up their broker letting them know they want to short sell one share of a business; here, the broker needs to find a stock to lend to the short seller.
There are different ways the broker can lend a share, such as looking through their stock inventory or contacting a firm’s loan desk to see if there are shares available for lending.
To simplify through an example, say an investor believes a company has overpriced stocks and predicts it may struggle in the future. To try and profit off this belief, the investor will call their broker to execute a short sale transaction.
Here, the broker finds one share from another client’s portfolio and borrows it — the broker will then lend the borrowed shares to the investor at its current market price. The investor then sells that share on the open market.
If the stock’s price was currently selling at $100 per share, $100 will be credited towards the investor’s brokerage account.
After a week or two, the predictions came true — the business continued to struggle financially, and the stock’s price dropped to $75. At this point, the short seller can buy back or recover by calling their broker and covering their short position.
The broker would use the $100 credited to the investor’s brokerage account to buy the stock at its new, lower price of $75, return the borrowed stock to where it was lent from, and allow the investor to keep the $25 profit.
Keep in mind that the investor will have to pay a small fee to the broker to cover borrowing costs.
Most investors, typically expert traders, can utilize this strategy by short-selling more shares on the stock market. How much money they earn will depend on their initial investment, as it can be much higher than the one share used in the example.
Understanding the Risks of Short Selling
As mentioned previously, short selling should be for experienced investors aware of the downside risk with shorting.
Short selling is pricey
When short selling, an investor will first need a margin account. Borrowing shares will result in a margin loan from a brokerage where the short seller will have to pay interest on any outstanding debt.
If you short a stock and the stock’s price increased, you will have to spend more money to recover from the losses.
Other fees factor in as well, such as borrowing costs.
Going short is seen as infinitely riskier than going long
When investing in stocks and holding a long position, an investor has a fixed maximum loss; this is the amount they initially paid for the stock.
Theoretically, the potential for gains is limitless. A person can buy shares at $25 per share, and that stock price could rise infinitely (depending on the company’s success and the time it takes to reach higher share prices).
When short selling, the gains are bounded, and the losses are limitless. Although a short seller can make back 100 percent profit if a shorted stock drops to $0, because there is no cap to rising stock prices, investors may end up paying back much more than they initially shorted.
Meme stocks, although relatively recent, are an extreme example of short selling gone wrong.
Large hedge funds heavily shorted companies they expected to perform poorly, such as GameStop, to profit off their speculations. With the help of social media, novice traders and a community of investors on Reddit invested heavily into these shorted stocks, intentionally raising the stock prices to unseen heights. A “short squeeze” was created causing these short sellers to cover their positions on their borrowed stocks, continually raising the overall stock price. This resulted in short-sellers losing out on a collective $19.75 billion on GameStop back in January.
Utilizing Buy-Stop Orders
To protect themselves from losing money and sharp stock price increases, an investor can set up a buy-stop order.
This type of stop order allows investors to set a specific price to sell their stock. If a security’s price rises and hits this limit, the stop would trigger, and the position would be covered at the current price.
Using the example above, if an investor were to short a stock at $100, they could set a buy-stop order with their broker for $110. At this point, even if a stock price soars dramatically, the stop would trigger at $110 and would cover the investor at that price. Although they would be looking at a loss in profits, the investor secures themselves from having to pay a higher price.
Wrapping It Up: Short Selling
Short selling is a unique take on investing and is often seen as an unethical practice due to funding companies that may be struggling to profit (the Securities and Exchange Commission, or SEC, actually regulates short selling and has set restrictions on it). Such as with other high risks, high reward investments, short selling offers investors the potential for fast, profitable results.
However, while there are methods to limit the risk, like with buy-stop orders, the risks still bear heavy. Incorrectly predicting a stock’s positioning can be detrimental depending on how much was shorted — because of this, short selling should be saved for knowledgeable investors.
