Have you ever stared at the screen long enough while watching a trade unfold and wonder to yourself would short selling be a good technique to learn? Many traders think the same thing and never get off the ground for a variety of reasons, whether it’s thinking they’ll lose their hard-earned money, or just not knowing what they’re getting involved in. They fall prey to what they read in the financial media about short selling, and much of it is inaccurate.
For whatever reasons, traditional investing websites, newspapers, and organizations tend to downplay the technique. The vast majority of those who advise against it do so for all the wrong reasons. Or, maybe you’ve heard the myth that short selling is what caused the Great Depression and the financial crisis of 2008. Wrong, and wrong. So, what are the truths about this interesting, very old way of doing business? Why do so many new investors want to know about it, and why do many everyday traders use it as one of the weapons in their toolbox? Here’s what to know about shorting, as many prefer to call it.
The Basic Concept
Before anything else, it’s imperative to understand the core concept behind short selling. For example, the idea is as old as time and has been used for as long as people have been buying and selling. The word short indicates that you, the seller, are making a legal commitment to deliver goods to a buyer in the future. That part is simple enough, so where does the idea of being short come in? When you make this contract to sell, let’s say the item is one share of ABC stock, you do not own the stock. Your supply of it is short, or in this case, non-existence.
Why would anyone ever do such a thing? Because prices fall. That’s why. Suppose you believe, based on in-depth analysis, that the price of XYZ shares is ready to fall from $10 to $7. You can’t be sure, but that’s your informed belief. Plus, you don’t own any amount of XYZ. A seller comes along who wants to buy 100 shares for the current price of $10. You sign a contract with the buyer which says they will deliver 100 shares of XYZ to you, tomorrow at the close of business for $1,000. Tomorrow, if your analysis was correct, and XYZ falls to the $7 level, you go onto the open market and purchase 100 shares for $700, deliver them to your buyer, who pays you $1,000, per the contract, and you pocket a profit of $300 on the deal.
It’s a Technique for Making a Profit
If you view short selling as just another way of making a trade, you’ll be on the right track. because that’s exactly what it is. Just as you might decide to go long by purchasing 100 shares of XYZ stock when you believe the price is about to rise, going short can be a wise move if you think prices are ready to fall. One of the best ways to approach the topic is to educate yourself. Fortunately, you can study a short selling guide and learn all the basic techniques, the pros, the cons, and learn how to spot a situation when shorting is the most appropriate thing to is. You’ll also learn, by reading such a guide, when not to short a security.
Downsides Exist
Obviously, there are downsides to the short selling approach. The main one is that your prediction of a falling price level on the security in question does not take place. Let’s say prices rise instead. You lose an amount equal to the price rise multiplied by however many shares of the stock you agreed to deliver to the seller. Note that the risk is essentially infinite because prices can rise by any amount.
Pros Outnumber Cons
If you know how to use short selling, have enough experience in placing orders, and work with a broker who allows you to use the technique, there are many advantages. The biggest one, and the most obvious, is that you can now aim to make a profit in a rising or falling market. Instead of going long on every transaction and hoping for values to rise, you can also identify securities you believe will go down in value and trade them via short-selling in the hopes of making a profit. Having another tool at your disposal means you will have more opportunities to make trades, even when your analysis shows that a particular company’s stock is about to decline in value.
