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What is short selling?

Short selling has been a feature of equity markets for many decades. Simply put, it’s the act of selling a stock (or other security) that the seller has borrowed from someone else. After that sale, the investor must “close” his or her short position by reimbursing the lender for the borrowed securities — in other words, they must buy shares to refresh their counterparty’s position(s).

Those unfamiliar with short-selling might find the concept nonsensical. Why borrow a stock when you can simply buy it outright? Well, there are some very good reasons.

Profiting from loss

With short-selling, investors are basically betting that the price of the chosen security will fall. They borrow the security, typically around the prevailing market price, in a move known as “opening” the short position. The investors then quickly sell it around that level. If the price subsequently drops, the investor will make money, since the cost of replacing the shares is lower than what it cost to borrow the original position. Replenishing the borrowed securities is known as “closing” the short position.

Typically, but not always, investors borrow shorted securities from their brokerage. In order to do this borrowing, an investor must have a margin account. This instrument allows brokerage clients to conduct borrowing activities like shorting.

Should you engage in short selling?

If you are new to investing, we don’t recommend that you dive into short-selling right away. Since it involves using leverage (i.e., borrowed assets), your downside risk can be considerable. For example, say you borrow 1,000 shares of XYZ Company at $10 per share to short. But the next day, some unexpectedly fantastic news is released about the company (yes, this happens). The market suddenly discovers it can’t live without XYZ stock, and bids it up to $15 per share (this also happens). In that case, you’d lose $5,000 on the investment, not counting interest charges.

Of course, there is downside risk to buying stocks “long” (i.e., the traditional method of purchasing and holding on to them in anticipation that their prices will rise). However, this risk is only limited to the total amount you paid for your stock — $10,000, in the above example.

There is no such floor with short selling. A security’s price can keep rising, and for especially volatile securities, this can happen suddenly and sharply. Shorting, then, is only recommended for experienced investors, particularly those comfortable with using leverage in their investments.

The controversy over short-selling

Since short-sellers profit on a stock’s decline, rather than its success, some have criticized it as a form of cannibal capitalism. Opponents have argued that the activity unfairly deepens the pain of a struggling company, making a difficult share price decline even harder to cope with.

Regardless, shorting is one of the fundamental tools of the modern investor, and as such, it’s not going anywhere. Even investors that don’t have any interest in shorting need to be aware of it –the short interest in any stock is an important gauge of how experienced investors view its prospects. As such, it’s well worth keeping an eye on with all stocks we have in our portfolio, plus any on our target list.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.