What is “Short-Selling”

Question

I just cannot, for the life of me, understand how you make a profit by it.

In: Economics

Answer 1

Short selling is selling an asset you do not own, so basically to open the position you sell and to close it you buy. This is in contrast to a long position where you just buy to open and sell to close. In order to sell something you do not own you need to borrow it from someone who does own it. Why would someone encourage activity that depreciates their own asset? Because they get paid interest for that borrowing, short selling alone is rarely enough to tank the price of a stock so if you own a stock that would tank anyways, might as well make money from it, but also because most brokers, rather surreptitiously, have share lending on by default and most people don’t bother to turn it off. It can also be a simple bet for some passive income by the stock holder that they can get interest from lending their shares expecting that it will go up eventually anyways so it’s a low risk option for them.

So when you’re the short seller, you sell a stock at the current price, let’s say 10$. So now you have 10$ from selling the stock you do not own. Within a predefined time frame, you have to buy it back to return it to the person from whom you borrowed it. If you’re right in your prediction that the stock price will fall, you buy it back at a lower price than what you sold it for, so let’s say 7$. You also pay interest to the person you borrowed the stock from, let’s say 1$. So you sold for 10$, bought back for 7$ and paid 1$ in interest, which leaves you with a 2$ profit from the price of a stock falling.

Short selling, and short positions in general, are a necessary mechanism not only for hedging but also for gauging sentiment and market outlook. It mitigates risk somewhat because whether the market is going up or down there is a way to profit from it which encourages investment. However that is not to say there is no risk or that it is easy. It just means that people are a lot more likely to invest and participate in the market if they’re not relying solely on the hope that stocks will only go up.