Short selling: you borrow shares from your broker of a company and sell them on the open market. If the price goes down, you buy them back, and you return the shares to your broker and keep the change.
Short selling example
I think company XYZ is going to go down in share price, but it is currently trading at $25 per share. I want to short 100 shares of it.
I borrow the 100 shares from my broker at $25 per share. I sell them on the open market, and receive $25 per share, or a total of $2500, for selling them.
A week later, the share price has fallen to $20 per share. That’s a loss of $5 per share.
I decide I want to cover my position, so I buy 100 shares at $20 per share, for a total cost of $2000. The 100 shares I borrowed from my broker are returned.
The profit I made was $500.
To recap: I sold 100 shares (that I borrowed from my broker) at $25 per share. So, I made $2500 on the sale, but still owed my broker 100 shares. I purchased 100 shares on the open market a week later, for $20 per share, or for a total cost of $2000. I returned the 100 shares to my broker, and kept the difference between what I first sold them for ($2500) and what I purchased them for ($2000). I made a net profit of $500… not including broker fees or commission.
And that’s how you can make money on short selling.
History of the Dow and S&P 500
I have never short sold anything, and probably never will. The reason: because stocks, overtime, go up, not down. Short selling is a gamble in my opinion; speculation at best.
According to Macrotrends.net, since February of 1915, until August of 2018, the Dow Jones Industrial Average (the Dow), has risen from 1386.56 to 25,964.82. That is an increase of 1,700%.
Shorting is very dangerous. Stocks, overtime, rise, they don’t fall.
For me, I don’t bet against the markets. No way! However, there are times when short-selling might make sense.
When short selling might make sense
Sometimes, companies hit hard times. Short selling might make sense in this situation. Take Enron for example, or a handful of other companies that went bankrupt. However, if they go bankrupt, and you have not covered your position, you will be on the hook to your broker for the number of shares you borrowed from them.
With that said, here are some reasons that shorting might make sense:
- Company falls on hard times
- The markets go into a recession
- Market corrections
- Bad earnings report
- Negative news
- Negative sentiment
- Political regulations on a product or products
These are just some reasons that shorting might make sense. Each one, of course, along with short selling in general, comes with unique risks.
Risks of short selling
- If company goes bankrupt, your on the hook for the shares you borrowed and can no longer buy back on the open market.
- Upside potential (profit) is capped, but downside (loss) potential is technically unlimited.
- You are betting against a market that has decades of data showing that it rises, and does not fall overtime.
- You are borrowing the shares from your broker on margin… fancy term for a loan.
I’m sure if I thought a little more, I would have more negatives to short selling to tell you. For me, short selling is not an option. Never has been, and unless something changes, it never will be an option for me.
There are too many risks. To me, it is speculation at best. And as you know, I do not speculate. I base my decisions solely on research and data. The way I invest is not gambling, it is a calculated risk. Short selling is gambling, it’s speculation.
Don’t get me wrong; there are a few very successful short sellers. However, the vast majority of short sellers get it wrong far more than they get it right. Too dangerous, and too much data going against you if you sort a stock.
I like to go with the flow, not against it. It’s about making money, not about the thrill of rolling dice and hoping your number comes up. The stock market does not have to be treated like a roulette wheel or a craps table.