If you are certain a stock will rise, simply buy it and make a profit. That is something almost everyone can tell you. However, what if the situation is the exact opposite? What if you believe a stock will drop substantially? How can you profit from that decline? The answer lies in short selling.
1. What is Short Selling
The idea behind short selling is the notion that you are trying to sell something someone else owns. One might probably believe that it is not possible. However, it is. But, how to do it? To put it simply, you borrow the instrument you wish to sell at the current price. Once you have sold it, simply wait for the stock to drop, buy it at a diminished value, and return it to the lender. This way, you can cover the debt, the lender receives his asset back, and there is a profit for you.
2. The Short Position
When you enter this position you are basically “short” a security. Essentially, you are indebted to your lender for the stock you have borrowed. This means that short selling also holds a risk in it. If the price does not drop before you have to return the asset you stand to lose money. In fact, since, theoretically, there is no telling how high a stock can go, you stand to lose unlimited amount. Of course, for that reason, you must be willing to cut your losses.
3. Common Uses
Short selling is commonly used either for hedging or for speculation. People who like to speculate will simply try to profit from a decline they are expecting to see. Hedgers, however, use this strategy to protect themselves. Short selling can be used to mitigate losses and secure their profits. Of course, you could use it for both of these goals. Institutional traders and individuals with enough knowledge can take advantage of both hedging and speculation at the same time.
In fact, hedge funds are the most active users of this strategy on both ends. They will both get into short position in some stocks and in the long position (being the lender) in other.
4. The Effect of Short Selling on the Market
While short sellers do profit on the failings of certain companies they are not a negative force on the market. A lot of people will tend to portray them as the “bad” guys who prey on the weak. However, this is not exactly true. Most of the times, the lender is the broker who is in control of the stock. Not the actual owner. Usually, you will not even know where the borrowed stock is coming from. All the risk in the situation lies with the broker and you. This is why there will usually be a commission for the broker. And short selling is actually very important for proper functioning during the “low tides”. Short sellers actually provide liquidity and keep investors in check to avoid inflating the stock values.
5. How risky is it?
Short selling is definitely not one of the safer strategies in trading. In fact, many avoid it as it can be too risky. In the long term, the equity market is rising. And there is, in theory, literally no limit to a stock’s rise. This means that an incorrect speculation can cost you a lot, especially if you do not keep track of it. However, under certain conditions, this can be a very profitable strategy for someone with a lot of experience. Especially if you are willing to accept the chances for a loss since the payout can be huge.