TL;DR
- Short selling, or shorting, means an investor expects a stock to lose value
- In a short sell, investors borrow stocks and immediately sell in hopes of making a profit
- Shorting is incredibly risky for investors, as a stock could trend infinitely upward in theory
- Trends in shorting can lead to a short squeeze, a phenomenon that occurs as a result of many investors shorting in a short period of time.
What is short selling?
Short selling is an investment strategy where the investor profits if the stock price drops. Someone will borrow shares under the agreement the stocks will be returned. The investor then sells the shares they just borrowed in hopes that the price goes down. If the price goes down, the investor will buy those stocks at the lower price and return the borrowed shares to the lender. The difference between the initial value and the shares lower price is how the investor makes a profit.
The risk(s) of shorting
Short selling, or shorting, is incredibly risky, because a stock price can only go so low, but theoretically grow infinitely upward. If an investor short sells a stock and the stock goes up, the investor loses money because they now have to buy the stock back at a higher price.
In other words, an investor who has bought a stock can lose 100% of their investment if the stock hits zero. A stock cannot be worth less than zero. However, if an investor shorts a stock, its possible to lose more than over 100% of the original investment, as stocks technically do not have limits to how high the price can go.
Other risks of shorting include timing. It may take a while for a stock price to decline. While waiting for the value to go down, you have to consider interest and margin calls.
How investors make money by short selling stocks
Even though a lot of investors try to select stocks that are going up, some investors will try to select stocks that are going down, this is the the general idea of short-selling. If a large portion of the market is dropping, investors may believe it is a safer bet to select stocks that are going down instead of trying to find stocks that are going up.
Withshorting, an investor will borrow a stock, sell the stock, assume it is going to go down, and then buy the stock at a lower price before returning it to the original holder. The investor will make a profit on the difference between the original sale price of the stock and the price at which he or she purchased the stock back. A lot of investors will decide to short sell stocks in order to protect their gains, minimize their losses, or hedge their risk against the market. Whenshort sellingis successful, investors can make a significant amount of money because stocks tend to lose value faster than they appreciate.
On the other hand,short sellinga stock is also riskier than traditional investing. With traditional investing, there is a limit to how much someone can lose, which is equal to the value of the original investment. Withshort selling, there is no limit to how much money someone could lose, as there is no limit to how much a stock could appreciate. Therefore, investors have to follow the market carefully if they are planning onshort sellinga stock.
What is a short squeeze?
When an investor shorts, they have to buy the stock back. If many people are also shorting, it may be difficult to find a seller to buy the stock back from, as theres now a spiked increase in demand. People may begin to panic and start buying stock back to cut their losses, which will cause the price to either stay the same (not depreciate) or could even increase. In a connected world, news could travel, inspiring people to buy more stock, which makes the price go up even more. This phenomenon is known as a short squeeze.
One of the biggest risks of ashort squeezetakes place if a margin call is issued. As ashort squeezeunfolds, many investors will buy the stock as it continues to climb sharply higher.Eventually, someone who isshort sellingthat stock may have a margin call issued by the original owner. As a result, that individual may have to sell off a bunch of his or her other holdings in an effort to cover the margin. If this happens to a lot of investors, this can cause the prices of other stocks to fall sharply as they are sold off to cover the margin call. This can have a serious impact on the market, worrying other investors who are having trouble making sense of the volatility
Learn more about market volatility here.
Bottom line
Short selling is an investment strategy when an investor expects that value on a stock to go down. Its extremely high-risk since investors are borrowing stocks they dont own and selling them. An investor may feel inclined to short if they own stocks in a particular industry but want to protect themselves from an industry wide risk by shorting a stock from a competitor. Its not recommended to short a stock unless you are an experienced investor who can carefully assess the risks involved.