Please enable JavaScript.  This webapp requires JavaScript to work at its best.

Market News

What is short selling, and why do investors do it?

20/01/2021

For many investors, the traditional way to make money from stock is to “buy low, sell high”: purchasing stocks when their price is expected to rise at a later date. This approach is not completely without risk – but for those who are even less risk averse, short selling can sometimes appeal as an alternative. But what is short selling, and why do investors do it?

 

Short selling, defined
Short selling, essentially, is the opposite approach. Instead of buying low and selling high, investors do the reverse: selling stocks that they borrow from a broker. The investor waits for the price of the stocks to decline and buys them back, and in the meantime in a short sale, they are charged interest on these borrowed stocks. When the short sale has been completed, the borrowed shares are returned to the broker (plus any fees and interest that have been accrued), and the investor keeps the remaining profits. The aim, therefore, is to borrow stocks where a large drop in price is expected, to maximise profits.

 

Why do investors choose to short sell?
The big draw of short selling is the opportunity to profit from markets and stocks that are declining, not just those in a period of growth. Many short sellers choose it as a strategy if they know that a company is likely to decrease in price – for example, if poor financial results are expected, or if the company is having management problems. It is also used for hedging: an attempt at minimising losses from other, related investments.

 

What are the downsides to short selling?
The biggest risk of short selling is that there is no limit to the amount of money you could lose. In regular investing, the maximum you could lose would be the funds that you invested. In short selling, however, there is no limit to the amount you could lose. While you are betting on a stock’s price falling, it could, instead, continue to rise indefinitely. This was the case for one investor in 2015, who placed a $37,000 short position on a pharmaceutical company, only to find that the share price rose by 800% a day later.

Every investment involves a degree of risk. In short selling, this risk is greater than most, and it is described by industry experts as a strategy that inexperienced investors should avoid, leaving it instead to more seasoned investors.

 

Stable Rise Limited is not authorised or registered by the Financial Conduct Authority. The marketing materials are not intended to provide financial advice nor promote any individual financial products.

Share this article

More reading
Forgotten your password?