What is short selling?

Definition

Advanced trading technique known as Short Selling involves borrowing stocks, selling them at the prevailing market price and anticipating a decrease in price to repay the borrowed shares at a lower price.

Understanding short selling

When investors believe that a stock price will drop, they can engage in short selling by selling borrowed shares at the current market price with the hope of buying them back at a lower price if the stock price does indeed decline. However, short selling carries more risk than traditional stock purchases, as the investor risks the possibility that the share price will rise instead of falling. This would result in the investor having to pay more to buy back the shares than their original value, and they would still be responsible for the fees associated with the borrowed shares. Additionally, the potential losses in short selling are unlimited because a stock’s price can rise infinitely.

Example

John, a fictional investor, believes that the share price of a fictional company named Watch World is too high due to the impending release of a groundbreaking watch by its competitor. To take advantage of this, John borrows 100 shares of Watch World using his margin account and sells them at the current market price of $15 per share. He then waits to see how the stock price performs. Eventually, the competitor's watch becomes a huge success and the stock price of Watch World drops by 15% to $12.75 per share. John buys 100 shares at $12.75 to return the borrowed shares to his broker. After taking into account the fees charged on the borrowed shares, John has made a profit of $225 by short-selling Watch World.

Gist

To earn profit through stock market, one must purchase stocks at a low price and sell them when their value is high. Short selling involves the opposite approach, where stocks are borrowed first, sold at the current price, and then bought back later when the price drops. The purchased stocks are then returned to the initial lender.