Short selling

Short selling is a trading or investing practice that allows investors to sell borrowed securities like stocks with the hope of making a profit by buying them back at a lower price later. In short, the expectation is that when you sell short a stock, you want to make a profit from its decline rather than the price increase.

The concept of short selling confuses many people because it involves selling something that you don’t own. In short selling, you borrow shares from a broker. Short selling is the sale of a security borrowed by the seller to buy the stock later. The investment gains in short selling only pay off when the security value comes down from the sale date to the purchase date.

Short selling has received both praises and criticism. Critics of short selling say that short selling leads to losses in the economy and to recessions.

How short selling benefits the financial market

Price efficiency – Short selling leads to price efficiency by measuring how accurate market prices reflect the available or provided information. This means that short selling allows prices of stocks to be more accurate and to reflect market participants’ collective opinion of the value.

Reduction of price bubbles – Stocks that are overvalued are a problem to the economy. If stocks are overvalued, short selling will indicate that that stock is overvalued and therefore will prevent a market crash.

Market stability – A market is termed to be more stable if it has enough liquidity. Liquidity is the ability of trades to occur in large amounts near the market price. Short selling ensures reduced volatility by increasing liquidity. This is because short-sellers always trade in the opposite direction of the movement of price. What is more short selling also promotes the stability of the markets by providing valuable indicators of overvalued, risky, or volatile stocks.

Short selling to make a profit – Short selling gives business people a new dimension of the movement of markets to speculate on. It ensures that traders can make money even when stocks drop in price. When many people a short-selling a specific asset, the company behind that asset is in trouble. However, short selling broadens the stock market by showing investors other ways to make money.

Short selling to hedge open positions – Hedging is another popular way to apply in short selling. It is a practice where you can hold two positions when offsetting losses in one position and making gains in another. In hedging, traders who have short positions can protect themselves from losses on a long position. A good example is when a stock you have invested in is about to decline, you can short sell it to reduce the risk of losses. Hedging does not necessarily prevent losses, but it can reduce the impact of the loss.

Rules you must follow when short selling

• You should only sell in bear markets – You must know when there is a bear market. When the prices of shares or stocks rise sharply, that is the best time to sell your shares. When the bull market is intact, you should not sell your stocks.
• Only short sell stocks that are trending down – Before selling your stocks, ensure that the odds are in your favor. Ensure that the stocks you are shorting are in a downtrend.
• Short sell when there is a public opinion about the company behind the stock that it’s about to fall – Stocks begin declining when investors lower their expectations about a stock’s future. When the expectations are low, people stop investing, and others start selling. This is the best time to sell your stocks short.
• Ensure that you know the mathematical realities of short selling – You must be aware that this is a risky market that involves a lot of risk-taking. If the market falls after short-selling, you will make profits. When the market rises after the sale, you will make a loss. You must know the dimensions of this market.
• Do not get greedy – Do not want to make too much profit because this is a high-risk market. When you make a profit from short-selling, take some time to study your next venture. Do not invest due to people’s pressure.

Disadvantages of short selling

In short selling you only make money when the prices of stocks go down. The real risk in this business is that when the prices rise, the potential losses are limitless. This is because you have to buy the stocks to return to your broker.

Short selling can make the price of a normal stock market drop or crash. If many traders decide to short a specific company, they may force it to go bankrupt. It is said that in 2008 short selling killed Bear Sterns.