Short selling is when an investor buys a stock expecting it will decrease in value in the future. Then the investor proceeds to sell the stock, and buy it right back just to return the stock back to the original lender for a potential net profit.
A short seller is essentially buying a stock that they anticipate will drop in the near future. With short selling you can actually make money from buying stocks that are dipping in price.
How Does Short Selling Work?
When investors short sell the profit would equal the difference between the buy and sell price. Short selling can be risky because there is no limit to the amount of money the investor could lose. The goal is to capitalize on declining stocks in order to net a profit.
Who Are the Typical Short Sellers?
Individuals will often short sell in order to hedge risks or just to speculate. They will attempt short selling strategies when they see a company is financially struggling or owes millions in debt to other businesses.
Hedgers will take an offsetting position in a stock that is similar to another share in order to limit the investment risk of the initial position.
Hedge Funds are very active in the practice of short selling. Hedge funds can be used to sell overvalued stocks and sectors in order to hedge their risks on the stock market.
Why Do Sellers Go Short?
Sellers will go short usually for the purpose of hedging or speculation. When investors anticipate massive stock price declines they often consider attempting a short selling strategy. If you can capitalize on declining stocks you can also protect your gains and mitigate your losses through hedging.
What Is an Example of Short Selling?
An example of short selling would be if an investor believes that the Netflix (NFLX) stock is overvalued at $557 per share, and thinks that it’s going to drop in price, then the investor may decide to borrow 20 shares of NFLX from their broker, who then sells it for the current market price of $557.
If the stock went on to drop to $400 a share then the investor could buy back his 20 shares at this price and return them to the lender for a net return. If the stock price were to do the opposite and go up to $800 then the investor would end up losing money.
Is Short Selling Regulated?
Short selling is 100% legal but many investors frown upon this selling strategy. When the stock market is performing poorly then regulators may impose restrictions to help balance out the system.
Why Do Investors Short Sell?
Only advanced traders should attempt to profit by predicting stock share prices. Short selling is very risky and can lead to huge losses. Investors short sell when they believe they have an opportunity to earn a profit from a stock that may start to perform poorly.
What Is Short Selling for a Profit?
Short selling for a profit means to borrow shares with the hope that they will drop in price in the future. Then proceeding to make a profit if the shares drop in price by profiting from the difference.
What Is Short Selling for a Hedge?
Investors will short sell to mitigate risks of potential declining asset prices in the future. Short selling for a hedge involves shorting an asset to hedge against future losses in an owned investment by selling at a specified price.
When Does It Make Sense to Short Sell?
Investors should short sell when they notice a downtrend and strongly believe the share prices of a stock will decline soon. When stock prices fall, opportunistic investors will short the stock right away for a potential net profit in the future. Investors will also track seasonal factors that exist on the stock market such as possible sector weaknesses.
What Are Ideal Conditions for Short Selling?
The ideal conditions for short selling would be first finding a stock that has been trending down but has continued to trade on the market for a significant period of time. This is a great indicator to investors that share prices will drop in the future.
A moving average is a stock indicator that is used by many investors because it helps to smooth out the price data over a specified period of time. Using a moving average can help you predict downtrends and notice short term fluctuations in different stocks.
Short Selling Pros and Cons
There are many pros and cons to short selling that investors need to be aware of before making any financial decisions.
Benefits of Short Selling
- Short selling provides investors with the ability to gain risk adjusted returns.
- You can reduce the market exposure of your portfolio by hedging your existing portfolios long term exposure.
- Short selling allows you to short an asset to hedge against future losses in an owned investment by selling at a specified price.
- Investors can reduce the volatility of their portfolio with exposure to short and long positions.
Risks of Short Selling
- News about positive developments of a company could encourage investors to buy shares in a stock that you are trying to hold a short position in.
- Change in legislation or even politics can alter stock prices very quickly and result in unexpected spikes and drops.
Financial Advisors Can Help You Short Sell
With short selling an investor will buy a stock expecting it will decrease in value in the future, then sell the stock, and then go on to return the stock back to the original lender for a net profit. The goal is to capitalize on stock declines in order to net a profit. When stock prices fall opportunistic investors will short the stock right away for a potential future net profit.
Financial Advisors can help you follow the stock market and place a short sell through your brokerage account. Additionally, they can help you set up an investment strategy to build your wealth. By guiding you, they will teach you ways to make better financial decisions to improve your financial security. You should consult a financial advisor to help you manage your investments while looking out for your best interests.