William Shakespeare famously said, “neither a borrower or a lender be.” While he was a legendary playwright, he was obviously not a player in the stock market. If he was, he might have learned of the value of short selling. There is borrowing involved in this trading strategy, but there is a profit-gaining method to such madness.
Short Selling Defined
Short selling is what happens when an investor sells off a security that is either not owned by the seller or that the seller has borrowed. There are several reasons why the investor may do this. It may be brought upon by a desire to hedge the downside risk of a long position in a similar or tangibly related security. It could also be caused by speculation. Regardless, the prime mover behind the action is a belief that the security’s price will drop, which would, in turn, allow it to be bought back at a lower price for profitability’s sake.
As one may guess, short selling is a tricky practice and should only be utilized by those that have solid market experience. It should also be solely utilized by those that are intimately familiar with the risks involved in the practice. Those that enter into the practice unaware of the risks involved could unwittingly place themselves in a pretty nasty financial downturn in a hurry.
How Short Selling Works
The idea behind short selling is to gain profit on a company’s losses. This is why a great deal of finesse and market knowledge is required. Because of the speculative nature of the practice, it’s imperative that the investor partaking in the practice has a firm grasp on analytics and a pulse on the news that pushes the market and its stocks up and down.
The reason why analytic know-how is so important is that of how short selling operates. The mechanics of the practice dictates that short sellers “borrow” stock with the anticipation of that stock taking a dip in market value. When this dip happens, they make a profit. When the opposite occurs, they take a bath. This is why short selling is not recommended for novices – to the inexperienced, the rules of this strategy seem backward with what they think they know.
What Does it Look Like When a Short Sell Works?
Let’s run a hypothetical on how a successful short sell would look like. After doing proper due diligence, the investor feels confident that a stock trading at $35 is destined to drop. As a result, the investor borrows 100 shares and sells them, leaving them “short” 100 shares of the stock. Fast forward a week later, and the investor’s prediction rings true. The stock dropped to $30, and that $5 gap in price translates to a $500 profit when the 100 shares are factored. The investor buys 100 shares of stock on the open market to replace the borrowed shares, pays the commission and interest to the entity that lent the stock out, and celebrates with a fancy dinner.
When Short Selling Goes Bad
Now that the good news has been broken down let’s analyze what happens when things go south. Instead of buying up the stock at $30, the investor decides to let it ride in hopes that it will drop a couple of bucks more. A few days go by, and it’s announced that the company behind the stock has something major happen to it that the market frames as positive, such as an acquisition. The news not only causes a palpable buzz, but it also spikes the stock price up to $45 a share. The trader is then left holding the bag on stocks that were borrowed lower than the buy price. The trader then has two options; cross their fingers and hope the price falls back, or buy the stock at a higher price and incur a loss in case the stock continues to climb. If the trader buys back the stock at the point of the $10 per share surge, they would be out $1,000. If the stock continues to jump, this loss could mount. As such, the trader buys the stock at a loss and drowns their misery in a plate of fast food somewhere.
Is Short Selling Ethical?
Short selling is not only a challenging practice to do right; it’s viewed in some circles as a downright evil practice. It may be fair to say that this practice is the Wall Street version of betting the “Don’t Pass” line on a craps table in Vegas: in both cases, you want something to happen that nobody else wants to see because that’s the only way your strategy can gain a profit.
There are some that also believe the practice of “betting for the house” sets a historically dangerous precedent. To wit: plenty of fingers point to short selling tactics as the key factor behind the market’s infamous 1987 crash. Even though there’s not a whole lot of concrete evidence to support this, the fact that such a sentiment exists provides one with a clue as to how unethical some feel the practice can be. As such, if you’re going to the market as a short seller, be prepared to make a few enemies along the way.
So Why Do Short Selling?
Despite the fact that short selling is a despised tactic by some, the practice is certainly not without its merits. It adds liquidity to share transaction, it drives down overpriced securities, and it boosts the overall efficiency of the markets by expediting price adjustments. What’s more, the practice can be used to pinpoint financial fraud. The scandalous Enron debacle that occurred in 2001 was initially uncovered because of short selling practices.
Again, short selling is not for everyone. It’s certainly not for those that are new to the market, nor is it for those that don’t have a whole lot of time they can set aside for proper analytics. But for the market savvy, short selling can be an exceptional tool to make a profit, if not a somewhat unorthodox one.