Have you ever been absolutely sure that a stock was going to decline and wanted to profit from that? Have you ever wished you could see your portfolio increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling. (To receive an eight week email series that complements this tutorial nicely click here to sign up.)
Short selling makes it possible to sell what one does not own, by borrowing the asset or instrument in question, selling it, and then buying it back (hopefully at a cheaper price) to replace the borrowed asset. As the seller does not own the asset, the process of selling it creates a short position (think of it as a shortfall) that must eventually be covered by buying it back on the market. The difference between the initial sale price and the price at which the asset was brought back represents the short seller's profit or loss.
Short selling is also known as "shorting," "selling short," or "going short." To be short a security or asset implies that one is bearish on it and expects the price to decline.
Short selling can be used for purposes of speculation or hedging. While speculators use short selling to capitalize on a potential decline in a specific security or the broad market, hedgers use the strategy to protect gains or mitigate losses in a security or portfolio. Hedge funds are among the most active short sellers, and often use short positions in select stocks or sectors to hedge their long positions in other stocks.
Short sellers are often portrayed as hardened individuals who are bent on profits and want the companies they target to fail. Additionally, many investors view short selling as an inordinately dangerous strategy, since the long-term trend of the equity market is generally upward and there is theoretically no upper limit to how high a stock can rise.
While shorting is inherently risky, the reality is that short sellers facilitate smooth functioning of the markets by providing liquidity, and also act as a reality check on overhyped stocks, especially during periods of irrational exuberance. Stocks may trade at sky-high levels or absurd valuations in the absence of short sellers’ restraining influence, and investors who buy into the hype could face massive losses in the inevitable correction.
Under the right circumstances, short selling can be a viable and profitable investment strategy for experienced traders and investors who have an adequate degree of risk tolerance and are familiar with the risks involved in shorting. Relatively inexperienced investors would also do well to learn about the basic aspects of short selling through learning tools like this tutorial in order to expand their investing toolkit.What Is Short Selling?
InvestingShort sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
InvestingIf more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
InvestingShort selling has a number of risks that make it highly unsuitable for the novice investor.
TradingThis strategy can help in market downturns, but it's not for inexperienced traders.
TradingThis figure can be a real eye-opener about the market sentiment surrounding a given stock.
TradingThe short squeezed strategy can be risky - but also very rewarding - for those who master it.