What is Short Selling?
What is Short Selling?
One of the gauges for public to determine the status of the economy is the prices of stocks in the market. Accordingly, the common perception is that the higher the prices of stocks, the better the economy is doing and the happier the investors become. Moreover, when one thinks of the relationship between stocks and investors, probably the first things that will come into mind are higher value of the stocks means more profit for the investor. For long-term investors, this relationship may be the general rule. On the other hand, a different relationship exists in the case of short selling.
In line with this, the term short selling is defined in the finance and business world as the process of selling lent equities and buying them when the prices of such stocks goes down, with the difference of the sale serving as the profit for the short-seller. Unlike the long-term investment in equities, the basis of this stock market activity is the speculation that the prices of stocks will fall down in the future.
Short selling usually involves four parties. They are the short seller, the owner of the stocks, the broker and the buyer of the stocks. The short seller acquires the services of a broker who are holding stocks from the owner. This broker will then lend the stocks to the short seller in behalf of the owner. The short seller will sell the stocks to the buyer, anticipating the decrease in the value of the equities in the near future. When the price of those particular stocks falls down, the short seller will then buy the stocks back, with the difference serving as the profit. After this, the short seller will pay the services of the broker and keep the rest as income.
There are two primarily reasons for short-selling. One is speculation and the other is hedging. Speculation is the most common reason behind short selling. This is to profit from eventual fall of prices of overpriced stocks. Meanwhile, others short sell equities due to hedging, in order to protect other long-term investments. Accordingly, they protect long-term investments by offsetting short-term positions.
Although this process may have brought profit to some investors, there are several risks factors, which may result losses to short sellers. The primary factor is the upward trend in the prices of stocks. Without any other major factors upsetting the natural course of the stocks’ movement, most of the equities appreciate after some time. Also, short selling involves borrowing of money. If the speculations are wrong, the losses incurred might be greater than expected, leading to financial disaster on the part of the short seller.
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