Definition
Short selling is a trading strategy where an investor sells a security they do not own, with the plan to repurchase it later at a lower price. This method is applied when an investor believes the price of a security will decrease in the future. The profit is the difference between the selling price and the repurchase price, but if the price increases instead, a loss occurs.
Key Takeaways
- Short Selling is an investment strategy where an investor borrows shares and immediately sells them, hoping they can scoop up more shares later at a lower price, return them to the lender, and pocket the difference.
- It can bring substantial gains with dramatic drops in a stock price, but it also carries high risks because the losses can be unlimited if the price continues increasing instead of falling as the investor expects. The potential losses are limitless because a stock’s price can keep rising indefinitely.
- Short Selling is usually done using a broker who is holding the shares in their account. However, there are strict regulations and margin requirements due to the high risk associated with short selling, making it less accessible for common investors and more targeted towards professionals and institutional investors.
Importance
Short Selling is a critical financial term because it lays the foundation for a unique investment strategy that allows investors to profit from a decline in a security’s price.
Instead of the conventional method of buying low and selling high, short selling involves selling borrowed securities with the expectation that their value will decrease, then buying them back at a lower price to return to the lender, hence making a profit from the price difference.
Understanding short selling helps investors hedge risk, take advantage of market downturns, and provides the financial markets with more information, contributing to price efficiency.
However, short selling also calls for careful risk management due to its potential of triggering unlimited losses.
Explanation
Short selling is a financial strategy used by investors who anticipate a decrease in the value of a security, such as a stock or bond. The purpose of short selling is to profit from that expected decrease.
By engaging in short selling, an investor hopes to buy the security back at a lower price in the future, thereby profiting from the price difference. This strategy allows traders to capitalize on falling markets and not only rely on traditional investing schemes which rely heavily on an asset’s appreciation.
In practice, short selling involves borrowing securities from a broker and immediately selling them on the market, with the promise to return the same quantity of those securities to the broker in the future. If the price of the borrowed securities falls, as the investor expected, they can then be bought back at this lower price and returned to the broker, keeping the difference in price as profit.
However, the short selling tactic can be risky because if the price of the securities increases instead of falling, the investor may find themselves purchasing securities at a higher price than they sold them for, resulting in a loss. It’s a speculative strategy that requires accurate market prediction and professional risk management.
Examples of Short Selling
Bill Ackman’s Pershing Square Capital Management – Herbalife: In 2012, the hedge fund manager Bill Ackman made a Billion-dollar short bet against health supplement company Herbalife. Ackman claimed the business model was a “pyramid scheme” and predicted the share price would fall to zero. His actions, including a high profile presentation detailing his claims, caught the media’s attention. However, this short position didn’t work out as he planned. Despite temporary drops, Herbalife’s stock price didn’t collapse, and Ackman finally exited his short position in 2018 at a loss.
George Soros – Bank of England: In one of the most famous examples of short selling, the billionaire investor George Soros was dubbed “The Man Who Broke the Bank of England” after he made over $1 billion in profit by short selling the British pound in
Soros predicted that the Bank of England would have to devalue the pound amidst political and economic pressure, and he was proven right when Black Wednesday occurred.
David Einhorn’s Greenlight Capital – Lehman Brothers: In 2008, investor David Einhorn, who runs Greenlight Capital, famously shorted Lehman Brothers before the investment bank’s collapse. Einhorn suspected Lehman was not accurately representing its financial position, particularly regarding their subprime mortgage holdings. His decision to short sell Lehman Brothers stock precipitated vast returns when the firm filed for bankruptcy.
FAQs on Short Selling
What is short selling?
Short Selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
How does short selling work?
Traders borrow shares of a stock or other investment and sell them in open market. They wait for the stock’s price to fall, then buy the same shares back at a lower price and return them to the lender.
What is the risk in short selling?
The risk in short selling is that it opens the seller to the potential of infinite losses, as a stock’s price can continue to increase with no limit. If the price of the stock increases after the trader has sold it short, they will have to buy it back at a higher price, resulting in a loss.
What does it mean to cover a short?
To cover a short means to buy back the securities that were sold short. This is done to close an open short position.
Can short selling be beneficial?
Yes, short selling can be beneficial when done correctly. It can provide market liquidity, drive down overpriced securities, and reveal fraudulent accounting practices. However, it does come with a high level of risk.
Related Entrepreneurship Terms
- Bear Market
- Margin Account
- Covered Short Selling
- Naked Short Selling
- Short Squeeze
Sources for More Information
- Investopedia: A comprehensive online resource that provides definitions and in-depth articles related to finance and investing, including short selling.
- NASDAQ: Offers news, analysis and stock quotes. They also provide educational content regarding short selling.
- Bloomberg: Provides global business and finance news. They have numerous articles and analyses related to short selling.
- Reuters: Offers breaking news in business and finance. They have resources related to short selling and its impact on the financial market.
