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Highlights
- Short selling refers to the selling of a stock that the seller doesn’t own.
- In short selling, investors borrow stocks whose value, they think, will decrease.
- While short selling may deliver huge profits, the losses can also add up quickly and infinitely.
Short selling is one of the most used strategies in stock markets. It refers to the selling of a stock that the seller doesn’t own. To simplify it further, it is the sale of a security that a seller doesn’t possess but is promised to be delivered.
Sounds confusing? If yes, it means you are a novice in the stock market and hence maintain distance from this popular stock market strategy.
Short selling should only be undertaken by experienced traders and investors. While short selling may be used by traders as speculation, investors are more likely to employ it to tackle the downside risk of a long position in the same security or an associated one. Even as short selling may deliver huge profits, the losses can also add up quickly and infinitely.
How does short selling work?
In short selling, investors borrow stocks whose value, they think, will decrease. Thereafter, these borrowed shares are sold to buyers willing to pay the market price. Before the borrowed shares have to be returned, the trader is betting that the price will continue to fall, and they can purchase them at a lower cost.
Advantages of short selling
- It injects liquidity into stock markets and helps to reduce stock prices.
- The strategy helps to better assist in price discovery and improves bid-ask spreads.
- Investors can reduce their overall exposure of an investment portfolio.
- The overall volatility of a portfolio can also be reduced.
- It adds to the meaningful risk-adjusted returns.
Disadvantages of short selling
- The short-selling exercise can be inherently volatile in nature.
- In case of a stock price appreciating, there is no way to limit potential losses.
- Short sellers run the risk of borrowed stocks being recalled by their brokers.
- It may lead to short squeezes.
- Borrowing stock can be difficult in less liquid stocks.
- Investors may find lesser liquid stocks more expensive.
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