Investing 101: What is Short Selling?

Short selling occurs when you sale security that you may have borrowed but do not own. Trading is usually motivated by the notion of the price of stocks in question declining. The trader believes that he can make a profit off the security if he sells it when prices are high and buys it back at a lower cost. It is important to note that those engaging in short selling do not want to rid themselves of the stock they are trading. The sole purpose of this type of trading is to make a profit from the securities in question.

Benefits of Short Selling

 

Short selling comes with many advantages, which include liquidity. This method also keeps securities from rising due to gradual bids caused by excitement and optimism.

 

Those looking to manage the overall risk of their portfolios especially stand to benefit from short selling since the practice involves trading stocks that may decrease in value shortly. You can sell said securities in before their value decreases and purchase them again right before their prices rise. Short selling, then, gives you the best of both worlds as you rid your portfolio of toxic securities only to pick them up again at a later time when their values are not as low.

 

The Risks Involved

 

With every benefit comes risk, and short selling is no different from everything else in life. One of the most significant dangers associated with the practice is that of a “short squeeze.” A “short squeeze” is a situation in which stocks experience a sudden spike in value. It may be the case that the seller trades securities at a low $500 one day only to see the value of such stocks soar to $1,500 the next day. In this case, the trader stands to miss out on $1,000 because of his haste. The problem becomes worse if the stocks remain at $1,500 or continue to increase in value.

 

Another risk in short selling is what is known as a “buy-in.” The term refers to the notion of a brokerage having the power to close a short position at any time if the owners of the securities up for sale decide that they want to keep them. In such instance, the short seller is out of luck after having wasted his time and possibly losing money on a deal that turned sour. Unfortunately, there is no way for a trader to know the intentions of the stock owner, which is why many are skeptical of short selling.

 

Conclusion: An Alternative Route

 

Since many deem short selling a practice for the experts, some who are not as advanced in the field resort to what is known as a “put” option. The “put” alternative also gives you the right to sell stocks that you feel are headed for a downward spiral. This option, however, comes with the benefit of you being able to lease the downward price movement of traded securities.

 

You stand to lose less when you purchase a “put” instead of engaging in short shelling with hopes of everything turning out well. Still, as with any activity on the market, the “put” option does not guarantee a profit. Such is the reason why individuals should proceed with short selling and “put” options only after fully understanding what the practices entail.