Short Selling

by Investing School on December 8, 2008

Traditionally when it comes to investing, it is about buying an asset.  We put down money to bet that we can profit by selling the same asset at a higher price in the future.  Short selling is almost doing this backwards.  When we short sell, we sell the asset that we don’t own with the intent to purchase it back at a later date.  In order for short selling to be profitable, we are betting that the future value of the asset is going to be lower.

While the risk of short selling may appear to be the same as being long, it is actually not true because the price of an asset can go higher indefinitely.

Let’s take a look at an example to illustrate:

Scenario 1: Say you buy a 25 shares of stock for $40 and spends $1000 dollars.  The most you can lose is $1000 if the stock goes to zero.

Scenario 2: Now if you are shorting 25 shares of that stock at $40 and it subsequently goes to $100.  You will have to come up with $2500 to buy it back, losing $1500!

Therefore, people that sell a market short generally need to be very active in the market to make sure they don’t lose their fortune.

Short Squeeze
In reality, the shares are actually borrowed from the lender and aren’t just created out of thin air. Therefore, the same rules of supply and demand apply.

A common phenomenon known as a “short squeeze” can happen when there are many people who is shorting a security.  This is because when good news about a security occurs, all the short sellers scramble to cover their short positions, inflating the prices by creating a sudden huge demand for that security.

Many people who aren’t familiar with short selling tend to forget that if you short a stock that pays dividend, you are required to pay the dividend as well.  This is a crucial point to remember, especially in a bear market because dividends tend to run high.

Another benefit of short selling is that it actually provides more liquidity to the security because there’s a bigger market for buying and selling.  Imagine a security that no one wants to own.  In this example, there will be no market without short selling as no one wants to buy and no one wants to sell.  On the other hand, having short sellers will allow this security to be shorted and increasing buying when sellers eventually cover their positions.

What it Means to Us
There are many ways to use short selling to your advantage in short term trading, but long term investors generally don’t bother with short selling because the long term outlook for investments are generally up.  Therefore, short selling are usually an investment vehicle for the short term so use it at your own risk and only with money that won’t affect your lifestyle if you lose it all.

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