Short Selling

May 11, 2012 Friday

Introduction

An investor who assumes that the value of stock which he owns is going to fall in future can sell that particular stock. But is there any chance of selling it and making profits even if he doesn’t own that particular stock? The answer for the latter situation is "Short-selling".

Short selling is a situation where the investors at first sell the stock and later buy it at the end of the day to square of the position. It is usually done when one feels that the value of the stock is going to fall.

Why to do it?

Short-selling is a tool commonly used by financial market intermediaries as a medium for their business.
Short-selling increases market liquidity and efficiency, sometimes helping to regulate prices, in particular in the case of shares that look overvalued.
Short-selling allows investors to realize capital gains, even on falling markets.

The risks involved

The sky is the limit on short-selling. Short-sellers' risk is unlimited since the upside potential of share prices is, theoretically, unlimited.

The major risk is that, if the price of the stock goes up instead of falling, then the investors end up in huge losses.
Investors having short positions on a stock could be tempted to manipulate the price by spreading false rumors in order to send the price down. This is illegal and can lead to punishment.
Short-selling carries delivery risk, when the short-sellers cannot buy the shares they have borrowed. The intermediary is particularly exposed to this risk, if he has not demanded a guarantee, such as cash or shares.