What is short selling?

Short selling is betting that the price of an asset will decrease.

The following example will help you understand how short selling works in practice.

Bill’s bet against ABC stock

Bill believes that the price of ABC stock is unjustified. Indeed, he has reasons to believe that the current price of $2 per share will soon decrease to $1 per share.

He immediately goes to see his friend Bob, who owns plenty of ABC stock. Bob doesn’t care about a temporary decrease in ABC’s stock price as he is convinced that ABC is a solid company with a great future.

Bill asks to borrow 1000 of Bob’s ABC shares and promises to return them in one week.

Bob agrees to lend Bill his shares. However, he demands collateral equal to the price of his shares in case Bill’s gamble goes wrong.

Once in possession of the shares, Bill proceeds to sell them on the market for the current price of $2 per share. He now has $2000 dollars in his pocket but owes Bill 1000 shares.

His strategy is to wait for the price to go down so he can buy back the quantity he owes Bill for cheaper than he sold it for and pocket the difference.

Five days later, just as Bill expected, the price of ABC drops to $1 per share and he buys 1000 shares for $1000.

He returns the 1000 shares to his friend Bill and pockets the $1000 difference.

That’s how a successful short sell works.

What happens if Bill is wrong and the price of ABC increases?

In the possible scenario that Bill’s prediction goes wrong and the price increases, he will have to pay out of pocket to buy back the quantity he owes Bob and withstand the loss.

If the price of ABC shares jumps to $5 per share, Bill will have to spend $5000 to buy the same quantity he sold for just $2 per share a few days before, weathering a net loss of $3000. The more the price of ABC stock increases, the more he will have to spend to buy the required quantity he owes his friend. If he can’t afford to buy the required number of shares, he will lose his collateral to compensate Bob.

Conclusion

Short selling stocks is incredibly risky business.

Your possible returns are limited, because the price of an asset can only reach zero, but your potential losses are infinite, because the price of an asset can increase infinitely!

Thus, short selling assets is a very speculative gamble that should only be carried out by experienced investors with deep enough pockets to weather severe losses.

Case in point: Short sellers lost nearly $3 billion dollars shorting Tesla stock, which rose an incredible 174% in just over two months!

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Disclaimer: This is not financial advice. Perform your own research and due diligence before investing in any asset. Be aware that investing can result in the loss of part or all of your investment.

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