In finance, a short sale is the sale of an asset that the seller does not own. The seller effects such a sale by borrowing the asset in order to deliver it to the buyer. Subsequently, the resulting short position is “covered” when the seller repurchases the asset in a market transaction and delivers the purchased asset to the lender to replace the quantity initially borrowed. In the event of an interim price decline, the short seller will profit, since the cost ofpurchase will be less than the proceeds received upon the initial sale. Conversely, the short position will result in a loss if the price of a shorted instrument rises prior to repurchase.
While stock prices are unpredictable, there are many signals and signs that may indicate a possible change in the prices. Short selling is the technique used to take advantage of prospective decline in the prices of a security.
Sellers sell a borrowed security, one they don’t own, at current price only to buy back for a lower price in the future. Since it is a strategy based on predictions, there is a higher level of risk involved. Therefore, a seller interested in the strategy needs extensive experience and knowledge that enables accurate forecast.
Why Do Traders Short Sell?
Buying Low and Selling High is the golden rule of stock trading. Short selling reverses the rule to help traders take advantage of a completely opposite situation. It is about Selling High and Buying Low. The reason short selling is considered important is because it plays a role in balancing the long end and short end. It allows for liquidity by preventing securities from being held to be sold at extremely high prices. As a result, the price discovery mechanism remains optimized. Therefore, short selling is considered an effective portfolio risk management tool.
How Does Short Selling Work?
Since the key aspect of short selling is the time of purchase and sale, the actual process is fairly simple.
That security sold is usually borrowed from a broker, sold at the current price i.e. higher price than the possible price in the future. Once the prices are down as predicted, the security is repurchased leaving trader a profit.
Here is an example that illustrates the process.
A certain trader predicts that the stock of a certain company, currently trading at $25, is about to experience a price drop. He contacts a broker to borrow 100 shares of the company’s stock. He sells the stock for $2500. As predicted, the stock drops to $20 a week later. The trader now buys 100 shares back in $2000. This leaves him a profit of $500. The shares are returned to the lender.
Short Selling Risks
There remains a risk that the shares, due to their low price, will be bought by another buyer or the company will get acquired by another company that decides to sell stocks at much higher prices. The trader will have to bear a loss in that case.
In some cases, the price may rise rather than decline, which can trigger a ‘short squeeze’, a situation where a huge majority of short sellers are trying to cover their positions. This pushes the share prices even higher.
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