Short selling gives you a way to profit when the price of a security is declining. This means that you can make money even when the market is contracting.
Short selling is an advanced method of investing, with plenty of risk attached to it. The most common form of investment is when you place your money in a given security because you believe that its price is going to rise over time. You are going ‘long’ in this position. Short selling is the opposite. You are ‘shorting’ a security that you believe is going to decrease in value.
How does short selling work?
A person will open a short position by borrowing the shares of the given stock or asset that the person thinks is going to decrease in value at a certain point in the future (the expiration date). The person will then sell these borrowed shares to those buyers who are willing to pay the current market price.
Before the person returns the borrowed shares, they are banking on the price dropping so that these shares can be bought at a lower cost and then returned to the lender. The potential loss of a short is theoretically infinite, as there is no cap on how high the price of a security can rise. This is why there is more risk attached to shorting than going long, as the max you can lose when going long is your invested sum.
Using short selling as part of a hedging strategy
While short selling speculation is commonly seen, using shorting as a way to cut downside risk is also popular among experienced investors. A hedge is an investment that has been made with the goal of reducing adverse price movements in an asset. If the price of an asset goes the opposite direction of what you predicted, at least you have reduced the downside somewhat by taking an offsetting position in another asset.
The idea is to protect certain gains or minimize the size of a potential loss. This is not usually something that will be used by retail investors because of the costs attached with doing so. An everyday example of companies using shorting as a hedging strategy is when airlines use short positions as a way to hedge against future rising fuel prices.
Risk vs reward of short selling
There are of course numerous pros and cons associated with short selling. There is the possibility of earning profits from betting on the decline of an investment, allowing you to make money when the markets are falling and not just when they are rising.
As you are initially borrowing the shares when short selling, there is little initial capital needed to begin a short. You also have the advantage of being able to use short selling as a way to hedge different positions.
The downsides of short selling are most notably related to the potentially unlimited losses that are on the table. You will also need a margin account, with interest being incurred. The costs associated with short selling to hedge positions is usually too costly for the average retail investor.
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