What is Short Selling, How It Works, and Why Use It

Short selling (or "selling short") is a technique used by people who try to profit from the falling price of a stock. Short selling is a very risky technique as it involves precise timing and goes contrary to the overall direction of the market. Since the stock market has historically tended to rise in value over time, short selling requires precise market timing, which is a very difficult feat.

Here's how short selling works. Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone who owns them with the promise that you will return them later.
You immediately sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you "cover your short position" by buying back the shares, and your broker returns them to the lender. Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses for borrowing the stock. But if you're wrong, and the price of the shares increase, your potential losses are unlimited. The company's shares may go up and up, but at some point you have to replace the 100 shares you sold. In that case, your losses can mount without limit until you cover your short position.

Here are a few reasons why short selling might make sense:

Sometimes shares aren't available to short. While we don't recommend short selling for the above reasons, you may decide to include it in your overall strategy. If you do, consider mitigating the risk by setting strict quitting prices (say a 20% loss per investment). If it reaches that limit, resist the temptation to hang on, thinking it's even more overpriced now. Successful short selling is all about timing, which makes it more like technical analysis than fundamental analysis.

Some short-sellers target the following types of companies:
By InvestorGuide Staff

Copyrighted 2020. Content published with author's permission.

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