Shorting stock has long been a common trading strategy for speculators, gamblers, arbitrators, hedge fund managers and individual investors. It goes for those who are willing to take on a potentially significant risk of capital loss. Shorting stock or short selling, involves selling stock that is not owned by the seller, or shares that the seller has borrowed from a broker.
The Motivation to Sell Short
Short sellers conduct these trades because they assume that the price of a stock is going down and that if they sell the stock now, they will buy it back at a lower price in the future. If they do so they will make a profit which consists of the difference between selling and purchasing rates.
Many traders do short selling simply for profit. Meanwhile, others want their downside risk to be hedged or covered if they have a long position. In other words, whether they already own the same or a similar stock outright.
How to Short ABC Shares and Its Example
Suppose you believe ABC’s stock price will be massively overvalued. On the other hand, the stock will collapse too soon. You continue to sell $50 each of the 10 borrowed shares, pocketing $500 in cash.
In fact, you may pay a small commission and may also have to pay dividends to the purchaser of your shares depending on the timing, but for simplicity these are omitted in the example. So you have $500 in cash now and have an agreement to buy and return the 10 shares of ABC stock at some stage in the future.
When the stock hits the price of $50, you will lose money. The reason is you will have to pay a higher price to repurchase the securities. And also, you return them to the account of the broker.
For instance, if the stock went to $250 per share, you would have to pay $2,500. And also you buy back the 10 shares that the brokerage owes. You are also keeping the initial $500 and the net loss will be $2,000.
On the other hand, if the business fails, the stock will be decoded and you can buy it back for a few pennies a share, most likely, with much of the earlier sales profits as income.