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How to Short a Stock: What is it and Why do Investors Short Stocks?

January 03, 20243 min read

There are very few highs that can match betting against the system.

Short selling is a financial instrument that can grant you phenomenal returns if you play your cards right.

So if you're wondering what short selling is all about, and want to know how to short a stock, then keep on reading!

What Is Short Selling?

Simply put, short selling is the instrument that allows you to profit if you believe that a stock is overpriced and you are betting on its value declining.

It is the sale of a security that you have - as the seller - borrowed, and you get to profit if the security's price drops.

You basically sell a security that you borrowed, then you're expected to buy it again at a lower price.

Your profit will be the difference between the original security's price and its new lower price.

Why Short a Stock?

Saying that short selling stocks and other securities are a risky business would be an understatement. However, as with any financial instrument, there are risks and benefits.

For short selling, if it's done correctly the returns can be astronomical.

Exhibit A: Michael J. Burry of Scion Capital's returns by basically short selling against the U.S. housing market before the 2008 Financial Crisis.

Short selling is based on a foundation of speculation, and the downside risk of a long position here is that it can be theoretically unlimited. For example, you are short selling on a stock that you believe its value will drop in the coming months.

Two months pass, yet the value of the stock is still the same. You hold steady to your belief that it will decrease, but you keep hemorrhaging until its price drops with no crystal ball to tell you when it'll drop.

Or even if it'll drop at all.

That's why short selling isn't necessarily considered a core "investment" strategy, and it's seen more like a speculative activity than a solid investment strategy.

However, before you go running for the hills, short selling has a stable and insanely useful purpose: hedging.

Hedging is seen as protection and works to mitigate potential losses in a volatile market.

How to Short a Stock

Alright, here's how it goes:

  • Borrow the stock or security you want to bet against

Start by contacting your broker and request to borrow the shares.

The broker will contact another investor who owns the shares you want to borrow, with the understanding that you'll be returning the shares back at a preset date.

Of course, you'll be paying fees and interest to your broker for the transaction.

  • Sell the shares and get your sale's profits

  • Wait for the stock's price to fall

  • Buy back the shares at the new lower price

  • Give back the shares you borrowed to the broker and pocket the profit difference

You need to keep in mind that there will be extra costs, which includes the brokerage fees, and you'll have to pay for the dividends that the stocks' company issued during your borrowing period.

Ready for Short Selling Glory?

Now that you know all about short selling as an investment and how to short a stock, you're ready to take the plunge with your eyes wide open.

David

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