The stock market is at its highest level ever with American equities trading at ridiculously high multiples. Many of you may be expecting a market crash, but how do you profit from a market downturn when everything is falling?
Short selling is a way for you to capitalise on falling stock prices. It is the sale of borrowed financial securities with the intention to return it later. How does this work? To illustrate how this works, we’ll use a potato as an example.
I think that the price of potatoes will fall and you are the potato distributor (It’s an example, don’t go shorting potatoes after this). I will go to you and ask to borrow a potato. Then I will sell the potato you lend me, on the market for $2. So now I have $2 in my pocket and the potato is in someone else’s hands. (Assume the potato doesn’t get eaten or go rotten) For some reason, the price of a potato falls to $1 and I buy back the potato to return to you. So I now have $1 because I sold it at $2 and bought it back at $1. In the real world, “the distributor” is the financial institution that facilitates your trade; for most of us it would be the brokerage company that you trade with, the potato is the financial security and the $1 would be thousands of times that amount. This is how shorting works.
Although this may sound like the opposite of going long it isn’t the exact opposite and there are some risks attached to shorting stocks. First, you need to pay interest when shorting. Why would the financial institution lend you someone else’s shares for free? So the longer you hold a short position, the more expensive it gets. Second, if you long a stock, the most you would lose would be your initial investment. However, if you short a stock and it goes up, your risk is unlimited and you can lose multiple times the amount of your investment so be careful! Lastly, you are also responsible for making any dividend payments to the person you are borrowing the stock from which can make things even more expensive on your end.
So with all these attached risks, why go through the effort of shorting something? Financial institutions usually short financial securities to hedge their long positions (they are using it to reduce risk). And it is also the main way to profit from a market downturn where the chances of you making money by buying and holding are extremely slim. It can be profitable if used correctly but only if you know what you are doing, so as always please do enough research before shorting anything!
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