While most people set out to buy stocks and hope they’ll rise in value, there is a different tactic some investors use called short selling. Rather than hope that an individual stock rises in value, short selling is more or less betting that the value of a certain stock will go down. It’s sort of like betting on which team will lose a ball game rather than betting on the team you think will win. Here we’ll take a look at what short selling is and why some investors do it.
What exactly is short selling?
In order to clearly explain the idea of short selling, let’s imagine there’s a trendy new company that’s just gone public due to the wild success of a game they’ve recently released. For the sake of example we’ll call them FAD Games, Inc. At the moment, no one can get enough of FAD Games’ new game and their stock shares are going for $100 a piece.
Meanwhile, you’ve got a shrewd investor named Bob. Bob’s been around awhile and he’s seen plenty of games come and go. Bob knows there’s no way that FAD Games, which has no other great products to speak of, is going to be able to ride out their success long term. He’s so sure of the company’s ultimate failure, in fact, that he’s willing to bet on it.
So Bob goes to his broker and asks to borrow 10 shares of FAD Games. Keep in mind, he doesn’t actually buy them, only borrows them. Then he goes out and finds a buyer for all 10 shares and sells them each for $100 a piece. Somewhere along the way, he may have to pay a small commission or dividends, but more or less he’s just ended up with $1,000 of something he never actually owned.
There is, however, a catch. At some point, he’s going to have to buy the shares back and return them to his broker. This can turn out one of two ways for Bob:
- His suspicions about the ultimate fate of FAD Games will eventually turn out to be correct. Say, for instance, that the stocks do indeed ultimately plummet and end up being worth only $10 a piece. Bob can then buy them all back for $100, give them back to his broker, and keep the extra $900 from his intial sell. Such a scenario is exactly what he’d counted on and was why he was willing to take the risk in the first place.
- The possibility of the second scenario is where the risk comes in. Should it prove that Bob was incorrect and that FAD Games has tons of other popular games that will keep their popularity intact for years, Bob is in big trouble. If FAD Games stocks should rise to say $200 per share, Bob still has to return them to his broker. In order to do so, he will not only lose the initial $1000 he made from his sale, but will also be responsible for coming up with another $1000 so he can afford to buy back and return all the stocks for $2,000.
To short or not to short
As you can see, short selling is not for the faint of heart or generally even a good idea. Attempting to short a stock comes with a huge amount of risk and can go very badly for you just as easily as it can go well.
Sometimes when investors or traders can tell that a large enough number of shares for a given stock have been shorted, they’ll even attempt to drive it up in order to ensure that short sellers will end up in the red.