Short Selling

What is short selling?

Short selling is when an investor borrows a security and sells it on the open market, intending to repurchase it for a lower price later. Short-sellers bet on a security’s price falling and profit from it. On the other hand, Long investors are hoping for a price increase.

Examples:

Let’s assume an investor believes a certain stock, ABC Corp, is overvalued. The trader borrows 100 shares of ABC Corp from a broker and sells it at the current price of \$40 per share. Assuming the stock price drops to \$35 per share, the investor can purchase 100 shares of ABC Corp and return it to the broker, pocketing the \$500 difference (sell price of \$40 – buy price of \$35 = profit of \$5 per share x 100 shares = \$500). If the stock price increases to \$45, then the investor would lose \$500.

Why is It necessary?

This is a critical component of efficient capital markets, providing positive advantages through promoting secondary market trading of securities through increased price discovery and liquidity and improving corporate governance and, ultimately, the actual economy.

Short selling allows traders to hedge their portfolios and can provide additional opportunities to profit from bear markets. It also offers investors the chance to diversify their investments, as opposed to buying and holding only long positions. Although short selling is often perceived as a risky strategy, when used in moderation, it can be an important component of diversification.

Short sellers play an active role in the market by helping to keep prices in check and ultimately making sure that assets are priced more accurately. Some investors claim that by forcing investors to think twice about buying high-priced assets, it can lead to prices settling at fair levels.

Finally, short selling also serves another purpose in providing liquidity in the market. Without it, investors that wanted to exit their position may not be able to, as the market for a particular asset can dry up. Short selling can be used to meet the demand for securities at times when it is not possible for investors to buy into a market and provide the liquidity that was lost.