With recent market fluctuations, the term “shorting a stock” has become more frequently discussed. It’s a term that is making a comeback, much like what we saw during the financial crisis in 2008.
Selling short stocks is a confusing topic, and it can also be pretty controversial as well. It doesn’t matter whether you’re discussing companies like GameStop, AMC, or Blackberry, or even just investing in the housing market; this topic remains at the forefront of discord.
In this article, Daniel Calugar will help to explain just what short selling a stock is.
What is Short Stock Selling?
The term short selling a stock is relatively self-explanatory, but there are many misconceptions about the term. There are also a lot of arguments as to whether it’s a good option or not. This practice is used most often when a stock is starting to fall. Ultimately, the investor is assuming that the stock will drop in price.
So the investor borrows stock and then sells it. Then, they turn around and repurchase it so they can return the borrowed stock. When they repurchase the stock, it is typically at a lower price, so a profit is made from the difference between the selling price and the buying price.
This is assuming that the stock moves as anticipated. It is a pretty risky practice, but it can be profitable when it is successful.
Short Stock Sale Example
To give you a better idea of this practice, consider this example. Remember that this is a hypothetical scenario. Let’s say you anticipate Apple Inc.’s (AAPL) stock will go down because it is overvalued at its current price.
The value of Apple is $127 at the time. An investor borrows ten shares of AAPL, and the shares are sold at the current market price immediately ($127). If the stock were to drop to $85 per share, the investor could buy the shares at that price and return them to where they were borrowed from (probably their broker).
In this scenario, the profit is roughly $420. This is calculated by ten shares at each price ($1,270 — $850).
This could also work the opposite way, and AAPL could go up instead to $200. This would have the opposite effect and cause a loss of $730 ($1,270 — $2,000).
The Risks of Short Selling Stock
This is not an everyday trading practice for most investors. It does pose a higher risk than traditional investment practices. Those who do operate using short sales will sometimes profit and sometimes lose.
In a typical investment purchase, an investor does not lose more than their initial investment because a stock can’t drop any lower than $0. But in a short sale of stock, the risk is infinite. The stock price could go up and up and never stop rising, in theory. It’s an unpredictable practice.
Most of the time, short selling of stock is used for hedging purposes because, in some scenarios, it might protect a gain or even reduce loss within a portfolio. The practice requires skill and expertise and certainly has no guarantee of success.