Going Short, also known simply as “short selling,” is a trading strategy where an investor sells a stock or commodity that they do not currently hold. Instead, the investor borrows the asset, sells it on the market, and later repurchases it to return to the lender. The primary objective is to profit from a decline in the price of the asset.
Mechanics of Short Selling
- Borrowing the Asset: The trader borrows the stock from a brokerage firm or another investor.
- Selling the Asset: The borrowed stock is sold in the open market at the current market price.
- Repurchasing the Asset: The trader later buys back the stock, ideally at a lower price than the initial sale price.
- Returning the Asset: The borrowed stock is returned to the lender along with any interest or fees.
Key Formula
The profit from a short sale can be represented as:
Examples and Illustrations
Consider a stock currently trading at $100 per share. An investor believes the price will drop and decides to short sell 10 shares.
- Initial Sale: Sells 10 borrowed shares at $100 each, receiving $1,000.
- Price Drops: The stock price drops to $80 per share.
- Repurchase: Buys back 10 shares at $80 each, costing $800.
- Return: Returns the 10 borrowed shares.
Calculation of Profit
Historical Context
Short selling has been part of financial markets since at least the 17th century. The practice became more structured with the advent of modern stock exchanges in the 19th and 20th centuries. Famous short sellers, such as Jesse Livermore and George Soros, have created significant impacts on markets through this strategy.
Risks and Considerations
Unlimited Loss Potential
One critical risk of going short is the theoretically unlimited loss potential. If the price of the asset increases instead of decreases, the trader could face substantial losses.
Regulatory Factors
Many markets have regulations concerning short selling, such as the “Uptick Rule” in the U.S., which aims to prevent excessive downward pressure on asset prices.
Margin Requirements
Short selling typically requires a margin account, where traders must maintain a certain level of equity in their accounts. Failing to meet these requirements can result in a margin call, where the trader must deposit additional funds or collateral.
Comparison with Going Long
Going Long involves buying an asset with the expectation that its price will increase over time. This contrasts directly with Going Short, which profits from a price decline.
Related Terms
- Going Long: Going Long is the practice of purchasing an asset with the hope that its price will rise. See [Going Long].
- Short Sale: A Short Sale is the act of selling a borrowed security with the intent of buying it back later at a lower price. See [Short Sale].
FAQs
What is the purpose of short selling?
Can anyone short sell?
What are the risks involved?
References
- “Short Selling,” Investopedia.
- M. De Groot, “Stock Market Speculation and Short Selling,” Journal of Financial Economics.
- U.S. Securities and Exchange Commission, “Regulation SHO.”
Summary
Going Short is a sophisticated financial strategy that involves selling borrowed assets to gain from hoped-for declines in their market prices. While it offers significant profit potential, it also carries considerable risk and requires a thorough understanding of market mechanics, regulations, and margin requirements. Effective short selling can be part of a diversified trading strategy for experienced investors.
