What is short selling?
A short sale transaction is the opposite of a traditional purchase of a stock. In a short sale, the investor borrows stock in order to sell it, with the obligation to repurchase the stock later. Instead of profiting if a company’s shares rise, the investor gains if the company’s shares fall.
Why would I want to short sell?
When you invest in a company, you are predicting that its value will grow over time. If you think a company’s fortunes are going to decline, however, then you want to sell the company short. Buying a stock is to invest with a company, shorting a company is to invest against the company. If you have good reason to think a company will see its prospects fade, short selling is your way to profit from this knowledge.
Give me an example where I’d want to sell short.
Remember that short selling is investing against a company. So imagine that in 2007, you were confident that Apple’s iPhone would come to dominate the smartphone industry. You bought stock in Apple and invested with that firm. For every winner, there’s a loser, and in this case, the losers would inevitably be the other mobile phone makers. For Palm, Nokia, and Research In Motion, if Apple was to gain market share, these firms would see their sales decline.
An investor confident in Apple’s prospects could also conclude it was likely that, say, Research In Motion’s profits would fall and as such, its shares would decline. As it turned out, the general stock market fell heavily in 2008, so an investor who only owned shares in Apple would have suffered losses during the decline due to general economic conditions rather than any issues specific to Apple.
However, if you sold short Research In Motion or other mobile phone makers, you would have been fine, as shares in the other phone makers dropped more quickly than Apple did, earning large profits on your short sale, hedging your position and sheltering you from the broader selloff in the market. When the market turned back up, Apple shares resumed their upward climb while the other phone makers saw their stocks stay in the dumps, widening gains for someone who invested with Apple and invested against its competitors.
So how does short selling work exactly?
What’s a sample trade look like? Alright. Let’s imagine that you’d realized that Netflix was eating Blockbuster’s lunch in the video rental space. However Blockbuster shares remained inexplicably high, as the market failed to realize the company’s impending doom. At this juncture, Blockbuster shares, ticker:BBI, were trading at $10 each. You sellshort 1,000 shares of BBI, taking the position that Blockbuster would likely crumble under the weight of Netflix’s competitive pressure.
Here’s what happens:
You sell 1,000 shares at $10 each. So, you receive $10,000 of cash in your brokerage account. In return, you now have an obligation to buy 1,000 shares of BBI in the future to make good on your earlier sale.
The stock subsequently drops to $3 per share. You decide to cash out on your trade. As such:
You buy 1,000 shares x $3 each. You pay out $3,000 of cash from your brokerage account. This retires the loan of 1,000 shares of BBI that your broker had extended to you.
Net result: You received $10,000 when you sold the stock short and later you paid $3,000 to buy the shares back. The $7,000 more you received than what you paid to buy the stock back is your profit. Pure and simple.