Cuapa Asset Management

Many are attracted to be investors because they feel bullish about an investment and want to buy it, hoping that they can cash out in the future for a greater amount. But what if someone believes the economy is in the tank and they would rather bet that an investment will fall in its value over time than rise? As luck may have it, this kind of investor is able to do so through a process known as short selling.

There are two types of investing related to equities: Long and short. Long selling means that the trader is buying the stock and holding it. Short selling means that the trader is selling shares of the stock which the seller borrows from someone who holds the shares, with the intent to cover the short sale of those stocks at a lower market price in the future.

The difference between the two sales is that an investor who goes “long” believes the stock will be bullish, while an investor who goes “short” believes the stock will be bearish. An investor who goes “long” has no future obligations because they own the shares they purchased, while an investor who goes “short” has to repurchase the same amount of shares they sold in order to return them to the person they borrowed them from.

If a share price goes up, the short seller loses money, whereas if it goes down, the short seller makes money. Here’s an example of how short selling works:

Assume Joe Trader thinks the price of Widgets Incorporated on the Imaginary Stock Exchange is going to plummet in the next few weeks. Joe decides to sell 10,000 shares of the company at $1 each, which puts $10,000 into his portfolio, and makes Joe liable to purchase 10,000 shares in the future to cover his short sale. It turns out that Joe Trader was correct, and Widgets Incorporated drops down to $0.40 per share. Joe purchases 10,000 shares at the new market price of $0.40 each, for a total of $4,000. The amount he originally sold the stocks for ($10,000), minus the amount he had to pay to cover the shorted stocks ($4,000), comes to $6,000, which is Joe’s profit on the trade.

If, however, the stock price shot up to $1.50 and Joe got nervous and had to cover it, he would end up paying $15,000 to cover 10,000 shares at the market price of $1.50, and would have only originally gained $10,000. This would result in a loss of $5,000 for Joe, but a trader who went long on the same trade Joe shorted would profit $5,000.

Remember, short selling can be risky since the investor does not actually own the shares that they sell and is therefore not able to weather unforeseen market fluctuations like someone who goes long. Make sure you only short a stock if you have enough money to cover it at a loss without going into severe debt.