What is Short Selling?
Short selling is the practice in which the trader or the investor sells the shares that he does not currently own. The securities are borrowed from a broker and then sold, hoping that the prices of the shares will go down, so that when the prices go down the investor can buy them at lower prices and return them to the lender.This process is called short selling. In this process, the investor is able to make profits in the bear market due to the difference in the low buying price and the high selling price. Here is everything you need to know about short selling.
What is short selling used for?
There are mainly two purposes for which short selling is used by the traders:
Hedging of risks: the most important reason for short selling is to hedge the risks. The trader may already hold a long position on the same or related securities and has the risk of the market taking a downward turn. In this case, the trader hedges his position by short selling the same number of shares on the same securities. The shares sold short protect the short sellers against the risk of the prices going down.
Speculation: another major purpose of selling a stock short is speculation. An investor may anticipate the price of a security to go down because of an impending financial disclosure or other factors. At this time, the investor borrows the shares from the brokers or financial advisors and sells them short at a high price. Later, when the price goes down, he buys the same number of shares and returns them to the lender. This results in profit because of the price difference between the sold shares and bought shares.
Advantages of Short Selling
Short selling helps in the price correction of the stocks that were overvalued. It provides the ability to the traders to make profits even in the bearish market. Short selling also gives the much-required liquidity to the market. The process has profit potential due to the price difference between the sold and bought shares. Short positions can also be taken at a margin payment.
Disadvantages of Short Selling
The risk potential of short selling is unlimited and could become one of the most terrible mistakes people make when investing. If the price of the short sold security goes up, the trader will bear infinite losses. Short selling also makes the market more volatile and may lead to destabilization of the entire stock market, which can mean irreparable losses if you don't know the ways investors deal with volatility. It can also cause the price of a company’s stock to roll down drastically, if a lot of investors start short selling the shares of the company. The unregulated and illegal forms of short selling can cause more harm than good and can be used for manipulation and fraud.
"The market can remain irrational longer than you can remain solvent,” is an important saying in the stock markets. Hence, short selling a stock, just because it has a high p/e is not a good strategy. During bull markets, an overpriced stock can get more overpriced. For this reason, it is best to always wait for the trend to change from up to down in any stock before attempting a short trade.