Short Selling: What Is It and Why Does It Work?

Short Selling

Most of us know the stock market, at least in concept. The idea is we buy assets like stocks and bonds, hold them for a period of time (hopefully a long time), and hope the value of those assets increases. When we sell, we make money. Pretty simple, right?

However, there is another method of investing called short selling that can be just as profitable – if done correctly. But, there’s a lot of misconception about what short selling is and whether or not it’s right for you. After the Gamestop fiasco, many investors are curious about this form of investing and exactly how to use it as part of their overall investment strategy.

In this article, let’s look at short selling and whether you should try it.

What Is Short Selling?

Simply put, short selling is the act of betting against a company's stock. In other words, you are betting that the stock will go down. This is also called “shorting the stock.”

Short selling involves borrowing company shares from someone else and immediately selling them on the open market, with the hopes of buying them back at a later time at a lower price. In other words, a short seller sells something they don't own to buy it back at a lower price and profit from the difference.

The mechanics of short selling may initially seem confusing, but it's a reasonably straightforward process. To illustrate, consider this example.

Let's say that you think the stock of XYZ company is overvalued and due for a decline. You might borrow 1000 shares of XYZ from someone who owns them and then sell those shares on the open market for the current price of $50 per share, netting $50,000. If the stock price drops to $40 per share, you can buy back those 100 shares for $40,000, return them to the original owner, and pocket the $10,000 difference (minus any fees or interest you incurred in borrowing the shares).

So why would someone choose to short-sell a stock rather than buy it outright? There are a few reasons why short selling can be an attractive option:

1. Making Money in a Down Market

One of the biggest advantages of short selling is that it allows investors to make money in a declining market. In fact, short selling can often be more profitable than buying stocks in a rising market because stocks tend to fall faster than they rise.

2. Hedging Against Losses

Short selling can also be used as a way to hedge against losses in a portfolio. For example, if an investor owns a lot of stocks in a particular industry or sector and is concerned about a downturn in that market, they could short-sell a company's stock within that industry to offset potential losses.

3. Capitalizing on Overvalued Stocks

Short selling is also an effective way to capitalize on overvalued stocks, and this is what happened with Gamestop. If a company's stock trades at a high multiple of earnings or has other overpriced indicators, short sellers can profit when the stock eventually corrects to a more reasonable valuation.

That sounds like a great idea, doesn’t it? It can be, but short selling has a downside: it’s typically very risky.

One of the biggest risks is that there is no limit to how high a stock can go, which means that short sellers can potentially lose an unlimited amount of money if they don't get out of their position in time.

In addition, short selling requires you to borrow shares from someone else, which can come with additional fees and interest charges. Finally, short selling can also be risky because it relies on the investor's ability to accurately predict market trends, which is never a sure thing.

In fact, a hands-off passive investment strategy has been repeatedly shown to make investors more money than active traders.

Despite these risks, short selling can be an effective strategy for investors who are willing to take on the additional risk. In fact, short selling has been used by some of the most successful investors of all time, including Warren Buffett and George Soros. These investors had made billions of dollars by short-selling overvalued stocks and profiting when those stocks eventually declined.

Is Short-selling Right for You?

Deciding whether to try short selling or not is a personal decision that depends on your individual investment goals, risk tolerance, and level of experience in the stock market. Short selling can be a high-risk, high-reward strategy that requires a lot of skill and knowledge to execute successfully.

In general, short-selling is probably not the best strategy for newer investors. Instead, get your hands wet with traditional investing until you feel comfortable branching out into a high-risk investment strategy.

It is important to understand that short selling involves borrowing and selling shares of a company, which means you are betting against the company's success. If the company does well, and the stock price rises, you could potentially lose significant money.

On the other hand, if you have experience in the stock market and are comfortable taking on higher levels of risk, short selling can be a useful strategy in certain market conditions. For example, if you believe a particular stock or sector is overvalued and due for a correction, short selling could allow you to profit from that decline.

Author: Steve Adcock

Bio:

Steve Adcock quit his job after achieving financial independence at 35 and writes about the habits millionaires use to build wealth and get into the best shape of their lives. As a regular contributor to The Ladders, CBS MarketWatch, and CNBC, Steve maintains a rare and exclusive voice as a career expert, consistently offering actionable counseling to thousands of readers who want to level up their lives, careers, and freedom. Steve lives in a 100% off-grid solar home in the middle of the Arizona desert and writes on his own website at MillionaireHabits.us.