Short Selling
Most of us think of making a "killing" by buying something at a low price and subsequently selling it at a much higher price. The buy-low, sell-high principle is, after all, the essence of making capital gains. However, the stock market affords another method for striving for capital gains and that is through short selling.
Investors ( and speculators) who believe a stock is selling at a bargain price will purchase it in anticipation of later selling the security at a higher price. They are bullish on the stock and expect it to increase in price. On the other hand, someone who thinks that a stock is overpriced and that it will decline, is said to be bearish on the stock. What that person could do is to perform a short sale and that is to sell this supposedly overpriced stock first and to buy it later. The difference between the sale price and the purchase price represents the investor's profit or loss. Naturally the investor would hope for the stock to decline in value after the sale has been made.
- For example, person A believes that XYZ stock overpriced at $89 per share and that it is due for a fall. He shorts (sell short) 100 shares at $89 and then keeps his fingers crossed. XYZ does decline in its price and A covers the short position by buying 100 shares of XYZ shares at the lower price per share. Thus he made a profit of the difference. Instead of buying at a low price and selling it at a higher price, A first sold at a high price and then bought at a low price.
On the whole, short selling is a very risky undertaking and is normally not practiced by the individual investor. There is no limit to the amount the short seller can lose. That is the inherent danger in short selling - the specter of unlimited losses. Therefore, it is best left to the institutional traders and arbitrageurs.
| Stock Main Page | Table of Contents | Corporate Finance Course |