Short Selling Explained
Short Selling may seem like a complex concept, and counter-intuitive that you are able to make a profit on something that goes down in price – but it’s rather simple!
The Short Explanation: (Absolutely no pun intended!)
Shorting is essentially betting against a Security like a stock (predicting the price to go down) – and you are only able to do this because you are allowed to borrow the shares and return them back at a later date. (But have to pay a fee or interest for doing so!)
How does it work? (Using a stock as an example)
- You will first borrow a stock that you want to bet against
- You immediately sell the stock you have borrowed at the current market value
- You wait for the share price to fall, after which you buy back the stock at a lower price
- You return the stock to the lender – and pocket the difference!
And obviously, if the price of a security like a stock were to go up and not down, you will possibly be making some serious losses! This is because you will need to return the shares eventually, and potentially buy them back at a higher price. This means the losses can be technically infinite! And the most you are to gain from shorting is the difference between the current price and the price crashing near to zero (minus interest costs & fees from borrowing the security).
Therefore: Short Selling is not suitable for beginners, as the risks are a lot greater than the potential gains, leaving no room for mistakes.
Another thing to consider is: If the stock price is highly unfavourable for the short sellers (it has gone up), they may want to hold off buying back the shares. But if they are holding back buying the shares there will typically be running interest costs. This means that eventually the short sellers will have to exit their short positions, or pay interest eternally. And if a lot of short sellers have shorted a company, and they want to exit their short positions (buy the shares back) at the same time – this will potentially drive the price up! This is called a Short Squeeze.
