Short Selling Stocks: Definition and Basic Explanation

Everything you need to know about one of the riskiest method of making money in Stocks Market

One of the most fascinating things about the financial market is how dynamic it is. Dynamic because of how many financial products there are and the numerous ways to make money.

One of the most interesting things about the financial market is that it is possible to make money when stocks and assets are moving up and when they are falling.

The stock market is the only industry that has this capability!

In this article, we will look at what short selling is, how to short sell, and the risks.

Strategies to Make Money in Periods of Low Volatility

What is Stock Short Selling?

There are two main ways of making money in the financial market.

You can buy an asset when its price is trading low and wait for the price to move up. This is the most common method used by participants to make money.

It is also the same way in which participants use to make money in other assets. For example, in this method, you could buy a stock at $10 and sell it at $15.

Short selling is the opposite.

Opposite, because it involves selling high and buying low.

How does Short Selling work

Assume that a stock of company A is trading at $20 and you have $1,000 to invest. After doing some analysis, you can find that the stock is overvalued. You predict that the stock could decline to $10.

With short selling, you will go to the market, borrow 50 shares and then sell them. You will still have the $1,000. You can then buy the stock when it reaches $10.

In this case, with your $1000, you will have 100 shares. You return the borrowed 50 shares and you are left with a profit of $500.

Let us summarize this example of short selling:

  • You have $1,000 and stock A is trading at $20.

  • You borrow 50 shares from the market. (Of course, there will be a small fee for this but let us ignore it.

  • You sell the stock. Now, you have $1,000 on hand.

  • After a few weeks, the stock falls to $10.

  • With the $1,000, you buy the same stock. You will have 100 shares.

  • You return the 50 shares to the original owner.

The advantage of short selling is that it enables you to make money when stocks and other assets are moving low.

For example, if a recession do happen, there is a possibility that short sellers will have a field day.

Another benefit is that it enables traders to be hedged.

What are the Short Selling Risks?

While short selling is a good method of making money, it is also the riskiest. It is riskier when you sell short than when you buy.

When you buy a stock at $10, the opportunities for making money are limitless. This is because a stock does not have a ceiling, it can move from $10 to $1,000.

In fact, this is something that has happened before. Think of Bitcoin that was trading at less than a dollar ten years ago and is now trading at $8,000.

Therefore, the worst that can happen when you buy a stock is to lose your entire money.

With short selling, you can lose more money than you had invested. This is known as a short squeeze (and here we explain how to avoid it).

In the example above, what if the stock rose to $30? In this case, you will sell the 50 shares for $30, meaning that you will have $1,500. This means that you will have to pay $500 more from your pocket.

In the past, several famous participants have lost a lot of money by short selling.

A good example of this is Bill Ackman, who is famous for losing more than a billion by shorting a company known as Herbalife.

Traders who sold short Bitcoin too have lost a lot of money.

Therefore, you should take time before you short sell.

External Useful Resources

  • The Difference Between Long and Short Trades – TheBalance
  • Short Selling Stocks: 10 Things You Must Know to Succeed – Timothysykes

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