In most cases, investors or traders would first purchase a security (stock, bond, etc.), hold it for some time (from seconds to years…), and, finally, sell it with the hope of realizing a profit. However, beginner investors may be unaware that the sequence of buying and selling can actually be reversed. That is, you can in fact first sell a security and buy it back from the market later. This is known as short selling.
- Define the concept of short selling.
- Understand the benefits and risks associated with short selling.
Short selling can be defined as the act of selling a security that you don’t own with an obligation to buy it back from the market to close your position at a future point in time. An investor (let’s call her Alice) who wishes to short sell a particular security first borrows that security from another investor (say, Adrian). Then, Alice can sell the security in the open market. The short position is closed when Alice buys back the security and returns it to Adrian.
You might wonder why any investor would want to do that. The reason is simple: Short selling is based on a belief that the security is currently overpriced and its price will eventually go down. The following example illustrates how an investor can profit from short selling.
A practical example of short selling
The current share price of Fictional Corporation is $10. Alice strongly believes that this price is too high. She thinks the fair price is around $9 and the market price will come down to that. Therefore, Alice instructs her broker to short sell 1,000 shares at the market price of $10. Consequently, Alice’s brokerage account is credited $10,000. After a couple of weeks, the share price indeed falls to $9. At that point, Alice decides to close her position. She asks her broker to buy back 100 shares of Fictional Corporation at $9/share, and her account is debited $9,000. As a result of these transactions, Alice pockets in a profit of $10,000 — $9,000 = $1,000.
The rights and obligations associated with short selling
This all sounds great, but short selling is a very risky activity. What if contrary to Alice’s expectations, the share price went up to $11 instead of going down? If she closed her position at that point, she would realize a loss of $10,000 — $11,000 = —$1,000. Well, she could remain put and wait for the price to go below $10. But, that may never happen. In fact, if the share price keeps going up, her losses get worse in parallel. For example, if the price goes further up to $14 and if she closes her position then (she must close it at some point!), her loss would be a whopping $10,000 — $14,000 = —$4,000. There is no limit to the losses Alice would experience if she kept her position open and if the security kept gaining value.
How about if the Fictional Corporation stock pays a dividend during the time Alice has a short position in this stock? Would she be entitled to that dividend? The answer is no. Alice would have to compensate Adrian, who is the legal owner of the stock, for any dividends paid until the short position is closed.
In summary, short selling allows investors to sell securities that they do not own. The idea is to profit from share price declines. However, if the price moves in the opposite direction, a short seller may be forced to close a position at a substantial loss. Given the high levels of risks involved with short selling, beginner investors would be wise to shun short selling as a strategy until they gain enough experience in investing and/or trading.
What is next?
This post is part of the series on trading basics. In the next post, we explain how arbitrage opportunities work in financial markets. In the previous post, we explained what is meant by holding a long position versus a short position in an asset.
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