The goal of short selling is to profit from a drop in the price of a stock or other security. It's a complex tactic that only seasoned traders and investors should try. Short selling can be used for speculative purposes by traders or as a hedge against the loss of a long position in the same or related securities by investors or portfolio managers. As a sophisticated trading strategy, speculation exposes investors to the potential for high losses.

Grasping The Concept of Short Selling

In short selling, the seller borrows shares, often from a broker-dealer, expecting to repurchase them at a lower price. You can't sell shares that don't exist; thus, borrowing them is necessary. To "cover" a short position, a trader will purchase shares on the market and then return them to the lender or broker for a profit. Traders must account for interest and charges charged by a broker.

Why Short Sell?

Short selling is typically done for speculative or hedging purposes. When a speculator bets on a price decrease, they are not considering any other factors. If they are incorrect, they will incur a loss by having to repurchase the shares at a higher price. Margin increases the inherent hazards of short selling. Hence the activity is often pursued speculative purposes over a shorter time horizon. Hedge funds use short sales to protect their long positions.

Profitable Short-Selling Example

Suppose a trader thinks the $50 price of XYZ stock will fall during the following three months. A hundred shares are borrowed and then sold to a third party. The investor sold shares they did not own but had borrowed, so they are now "short" 100 shares. The stakes must be borrowed from a third party, which could only sometimes be achievable if other traders extensively short the company.

Negative Short Sale Performance Example

Let's pretend the trader above did not close out his short position at $40 but instead kept it open in hopes of profiting from a further decrease in price. The stock price rises, though, when a rival bids $65 a share to acquire the firm. The $1,500 short sell loss if the trader closes the transaction at $65.

Hedge Fund Short Sale Example

Short selling serves another purpose besides speculation and is often seen as a less risky and more respectable version of the practice. In contrast to the purely profit-driven nature of speculating, the primary goal of hedging is risk management.

Short Selling: The Pros and Cons

If the seller makes an incorrect prediction regarding the price direction, the sale might be disastrous. If a stock a trader has purchased falls to zero, the trader will lose all of their initial investment. Traders who short stocks, however, risk losing much more than their initial investment. The danger lies in that stock prices can theoretically go "to infinity and beyond," to paraphrase the beloved comic book character, Buzz Lightyear.

Short Selling: Some More Things to Think About

There are other hazards associated with short selling that investors should be aware of, in addition to the risk of losing money on a deal due to a rise in a stock's price.

Funds Needed to Short Are Borrowed

Margin trading is another name for shorting. You must first create a margin account to borrow money from your brokerage business using your investment as collateral for short selling. It's easy to let your losses snowball when you go long on margin and have to keep at least 25% in your account at all times.

Faulty Timing

It may take some time for a company's stock price to drop, even if it is overvalued. Interest, margin calls, and removal are all risks till then.

Compress Quickly

A short squeeze can occur in a company with a high short float and days-to-cover ratio that is aggressively shorted. As a stock begins to climb, short sellers "squeeze out" their losses by "buying back" their short holdings. A virtuous cycle may result from this purchasing. Increased buying interest drives the stock price higher, prompting more short sellers to cover their bets.

The Conclusion

Investors and traders can profit from a falling market by engaging in short selling. Individuals with a pessimistic outlook might sell shares they have borrowed on margin and hope to buy them at a reduced price. Short selling has been called a "bet against the market," but many economists argue that it increases market efficiency and acts as a stabilizing influence.