I just cannot, for the life of me, understand how you make a profit by it.
In: Economics
Short selling is borrowing something and selling that thing. The idea is that the price will go down between the time you borrow it and the time you return it and that you can buy it back at the lower price prior to returning it.
simplified example:
You borrow 100 shares of XYZ company that are trading at $100 per share (you have borrowed $10K worth of XYZ shares) on October 1. You will pay the person you borrowed them from some interest rate (say 10% per year).
On Novmber 1, XYZ shares are trading at $80 per share. You buy 100 shares at $80 and return them to the owner along with $82.50 in interest (10% annually divided by 12 months = 0.825% for one month of borrowing)
You got $10K when you sold the shares you borrowed. You paid $8k for the shares when you returned them. You paid $82.50 in interest so you mad $1917.50 in profit
Of course, if the price of XYZ stock goes up then you lose money.
Normal way: Buy low, sell high.
Short-selling: Sell high, buy low.
How do you sell something you don’t already own? You borrow it. And once you borrow something you have to give to back.
So you: borrow shares, sell high, buy low, return shares. The difference is the profit (or loss).
Here are the basic steps to short selling:
– Borrow shares and sell them at market price
– Wait for stock to go down in price
– Buy shares to return ones borrowed, at a lower price.
– Difference between what you initially sold shares for and what you spent to replace them is your profit.
Imagine you shorted 100 shares of a stock trading at $10. You now have $1000 but still owe the return of shares borrowed. A couple months later, the stock is trading at $7. You buy the 100 shares to cover your short, spending $700. The $300 difference between the $1000 and $700 is your profit.
I borrow 100 shares. Sell them for $1000. price drops. Buy them back for $800. Return the 100 shares.
I made $200.
Short selling is like borrowing your friend’s toy to sell it to someone else because you think the toy will become cheaper soon. Later, when the price drops, you buy the toy back for less money, return it to your friend, and keep the difference as your profit. But if the toy’s price goes up, you’ll have to buy it back for more, and you could lose money.
Something I wish I knew how to do when I started investing in cannabis stocks 10 years ago. I’d be a billionaire by now if I could do it.
Lend me 1000000 Turkish Liras, I’ll pay you back next year.
But Turkish Lira is dropping in value like a rock, so when I pay you back, actually I will be paying you much less than I borrowed. And the difference is my profit.
Same thing works with any financial asset you expect to drop in value. You borrow, sell, and buy back cheaper when it’s time to return the asset.
With stocks, you can sell a stock that you have borrowed from someone. This is usually not the case with common items we borrow or rent.
But imagine that renting and selling real estate was like stocks:
You believe a hurricane is coming to an island. You then rent a room for $1 at a building there and immediately sell the room for a good price, say $20. The hurricane comes and the room selling price drops dramatically. You then repurchase the room at a low price, say $10, and return the room. You just made – 1 + 20 – 10 = $9
If the hurricane never came, and perhaps the island continued to prosper, you would have to buy the room back at say $30. And thus lose money: -1+20-30= -$11
When short selling, you are betting on the tanking of a stock.
I think the question I have following these answers is, who are all these people who have so many shares to “lend”???
Let’s say you agree to buy 10 apples from me. Today, they are $1/each, so we sign a contract at this price. But silly me, I don’t have the apples right now. So you give me a week to get you your apples. A week later, I am able to find apples at $0.50/each. So I buy 10 of them knowing I agreed to give you 10 apples. I then sell those 10 apples to you at the agreed upon price. I spent $5 getting the apples, and earned $10 selling them to you, making a profit of $5 in the process.
But what about if the price of apples had gone up to $1.50/each instead of going down? Well, since I still signed a contract with you to sell 10 apples for $1/each. That means I have to now buy apples at $1.50/each just to sell them to you right away for $1/each, losing me $5 total instead of being a profit.
This is what short-selling is. It’s using a price now for a future sale. The person doing the selling is hoping the price goes down so they buy shares of a company later at a (hopefully) lower price to turn around and sell immediately at the previously agreed upon higher price. On the other side, the person doing the buying wants the price to go up, because then that means they got a huge discount on the share, which they could then immediately sell after obtaining the share for a profit.
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