What is short selling?
This video explains short selling in the stock market in simple terms.
To understand how short selling works, let’s start with getting familiar with the terminology
of long positions versus short positions.
Let’s take a look at the share price of a fictional company called Toy Giraffe Inc.
The share price has been going up and down in the $80 to $100 range over the past years.
Meet John.
He does not currently hold any shares in Toy Giraffe Inc,
and expects the share price to go up.
John is going to take a long position.
Meet Jane.
She does not currently hold any shares in Toy Giraffe Inc,
and expects the share price to go down.
Jane is going to do the opposite of John, and take a short position, or short sell.
How to go “long” and hope to win?
Here’s what John is going to do.
He buys shares at $100 per share, hopes that these go up to $120,
and then plans to sell them.
If his expectations are correct, he could make a profit of $20 per share from the share
price going up.
Always read the small print at the bottom!
The $20 per share is John’s profit before any commissions, fees, or interest that he
pays to his broker or bank.
John’s investment strategy by taking a long position is: try to buy low and sell high.
How to go “short” and hope to win?
Here’s what Jane is going to do.
She borrows shares from someone else, through her broker,
when the share price is at $100 per share.
She sells these shares that she has borrowed, and hopes that the share price goes down to
$80, when she plans to buy back the shares and return them to the lender.
That’s how short selling is intended to work.
If her expectations are correct, she could make a profit of $20 per share from the share
price going down.
Once again, read the small print at the bottom!
The $20 per share is Jane’s profit before any commissions, fees, or interest that she
pays to her broker or bank.
Fees on short selling could be higher than on holding a long position.
Jane’s investment strategy by taking a short position is: try to sell high and buy low.
Even though John and Jane have different expectations of the future share price, there can only
be one actual share price.
Let’s assume that one year from now, the share price is $120.
In that case, John will gain and Jane will lose.
John bought the shares at $100 per share, and sold at $120, earning $20 per share.
Jane sold the shares at $100 per share, buys them back at $120, losing $20 per share.
The opposite could also occur.
Let’s assume that one year from now, the share price is $80.
In that case, Jane will gain and John will lose.
John bought the shares at $100 per share, and sold at $80, losing $20 per share.
Jane sold the shares at $100 per share, buys them back at $80, earning $20 per share.
Let’s test for a more extreme scenario.
Toy Giraffe Inc goes bankrupt, and the share price becomes zero.
John bought at $100 and sells at $0, losing $100 per share.
Luckily for John, his loss is maximized at the original amount he invested.
Jane makes a significant gain.
She sold the shares she borrowed at $100, buys them back at $0, and gains $100 per share.
Jane’s gain is limited to the difference between the current share price and zero.
Let’s test for an extreme scenario in the opposite direction, which shows that the risk
profiles of long positions and short positions are not symmetrical.
Toy Giraffe Inc does very well, the share price skyrockets to $1000 per share.
John bought at $100 and sells at $1000, earning $900 per share.
If he does not sell yet, but holds onto his long position, and the shares continue to
rise to $2000, he could earn $1900 per share.
Jane does not look so happy anymore.
She sold the shares she borrowed at $100, needs to buy them back at $1000, and loses
$900 per share.
Or even worse, if the shares continue to rise to $2000, she might lose $1900 per share.
Jane’s loss is potentially unlimited, and it could completely wipe her out.
Jane might have to sell her house and all her other possessions to settle the debt.
In summary: “going long” means that you expect a share price to go up
and take a position accordingly.
You buy a share, and intend to follow the “buy low, sell high” strategy.
Your loss is limited, as you could lose only the original amount you invested.
Your gains are unlimited, if the share price continues to rise.
“Going short” or “short selling” means that you expect a share price to go down and
take a position accordingly.
You sell a share that you borrowed, and intend to follow the “sell high, buy low” strategy.
Your gains are limited, because the “best thing” that could happen to you is for the
company to go bankrupt and its shares to sink to zero.
Your loss is unlimited,
as you could lose many times the original amount of your short position.
I hope you enjoyed this explanation and discussion of short selling.
If you enjoyed this video, then please give it a thumbs up!
On this end screen, there are a few suggestions of related videos you can watch next.
Please subscribe to the Finance Storyteller YouTube channel!
Thank you.