Going Short
Going short, also known as short selling, is a trading strategy used by investors who anticipate that the price of a security, such as a stock or a commodity, will decline. When an investor goes short, they sell a security that they do not currently own, with the intention of repurchasing it at a lower price at a later date. If the price does indeed fall, the investor can buy back the security at the reduced price, returning it to the lender, and pocketing the difference as profit.
Examples
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Short Selling a Stock
- An investor believes a particular company’s stock is overvalued at $100 per share. They borrow 100 shares and sell them, receiving $10,000. Later, the stock price drops to $80 per share, and the investor buys back the 100 shares for $8,000. The investor returns the borrowed shares and keeps the $2,000 profit (excluding fees and interest).
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Short Selling a Commodity
- A trader expects the price of crude oil to fall from $50 per barrel. They borrow 1,000 barrels and sell them for $50,000. If the price drops to $40 per barrel, the trader buys back the 1,000 barrels for $40,000, returns them to the lender, and retains the $10,000 difference as profit (excluding fees and interest).
Frequently Asked Questions (FAQs)
Q1: What are the risks of going short?
A1: The primary risk is the potential for unlimited losses because there is no theoretical limit to how high a security’s price can go. If the price rises instead of falling, the investor must cover the position at a higher price than the selling price, resulting in a loss.
Q2: Can any investor go short on stocks?
A2: Most brokerage accounts allow for short selling, but the investor must meet certain margin requirements and maintain sufficient funds to cover potential losses.
Q3: How is short selling regulated?
A3: Regulations vary by country, but common rules include the requirement to borrow the securities before selling (known as a ’locate’ requirement) and minimum margin requirements to manage risk. Specific rules may include restrictions on when and how short selling can be initiated.
Q4: What is the difference between short selling and put options?
A4: Short selling involves borrowing and selling the actual security with the hope of buying it back at a lower price. A put option, however, gives the holder the right, but not the obligation, to sell the security at a predetermined price within a specific timeframe.
Q5: Why would an investor choose to go short instead of selling call options?
A5: Going short is often used by traders who believe that a particular security is significantly overvalued and will drop in price. Selling call options involves a similar belief but focuses on collecting premium income rather than capitalizing on the full decline in security price.
- Going Long: Buying securities with the expectation that their value will increase.
- Short Sale: The actual transaction of selling borrowed securities in anticipation of a price decline.
- Margin Call: A broker’s demand that an investor deposit additional money or securities to cover possible losses.
- Hedge Funds: Investment funds that may employ short selling as part of their strategy for generating returns.
Online Resources
- Investopedia: Comprehensive guide on short selling.
- SEC.gov: Official regulatory information about short selling.
Suggested Books for Further Studies
- “The Little Book That Still Beats the Market” by Joel Greenblatt
- “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein
- “The Intelligent Investor” by Benjamin Graham
- “Flash Boys: A Wall Street Revolt” by Michael Lewis
Fundamentals of Going Short: Investing Basics Quiz
### What is the primary goal of going short?
- [ ] To profit from a rising stock price.
- [ ] To hedge against market volatility.
- [x] To profit from a declining stock price.
- [ ] To leverage dividend returns.
> **Explanation:** The primary goal of going short is to profit from a declining stock price. Investors sell a borrowed stock hoping to buy it back at a lower price.
### What must an investor do before short selling a stock?
- [ ] Obtain approval from the company's CEO.
- [x] Borrow the stock they wish to short.
- [ ] File a report with the SEC.
- [ ] Buy an equivalent amount of call options.
> **Explanation:** An investor must borrow the stock they wish to short. They then sell the borrowed stock and aim to repurchase it at a lower price.
### What is a key risk of going short?
- [x] Potential for unlimited losses.
- [ ] Limited investment choices.
- [ ] Paying taxes upfront.
- [ ] Owning the stock permanently.
> **Explanation:** Going short carries the risk of unlimited losses since a stock's price can theoretically rise indefinitely, requiring the investor to buy it back at a higher price.
### Why might an investor choose short selling over buying put options?
- [ ] To secure long-term investment growth.
- [x] To capitalize fully on a price decline.
- [ ] To minimize transaction fees.
- [ ] To avoid regulatory scrutiny.
> **Explanation:** An investor might choose short selling over buying put options to capitalize fully on a price decline. Short selling benefits directly from the stock's entire downward movement.
### What term describes the brokerage requirement to maintain sufficient funds to cover potential losses on a short sale?
- [ ] Equity balance
- [ ] Net capital
- [x] Margin requirement
- [ ] Reserve account
> **Explanation:** A margin requirement is the brokerage requirement to maintain sufficient funds to cover potential losses on a short sale. It helps manage risk for both the investor and the broker.
### Which agency regulates short selling in the United States?
- [ ] The Federal Reserve
- [ ] The World Bank
- [ ] The Financial Industry Regulatory Authority (FINRA)
- [x] The Securities and Exchange Commission (SEC)
> **Explanation:** The Securities and Exchange Commission (SEC) regulates short selling in the United States. They set rules to ensure fair and orderly markets.
### What is a margin call?
- [ ] A strategy to increase stock liquidity.
- [ ] A dividend payment announcement.
- [ ] A return on investment calculation.
- [x] A broker's demand for additional funds to cover losses.
> **Explanation:** A margin call is a broker's demand for additional funds or securities to cover potential losses in a margin account. It ensures the account meets margin requirements.
### What is the difference between short selling and going long?
- [ ] Short selling involves special fees not applicable to going long.
- [ ] Going long requires regulatory approval.
- [x] Short selling expects a price decline; going long anticipates a price rise.
- [ ] Going long cannot be done on margin.
> **Explanation:** Short selling expects a price decline, while going long anticipates a price rise. Investors sell borrowed securities when short selling and buy and hold when going long.
### How do hedge funds use short selling?
- [x] To hedge or gain profit from declining securities.
- [ ] To avoid paying management fees.
- [ ] To increase market liquidity.
- [ ] To stabilize bond prices.
> **Explanation:** Hedge funds use short selling to hedge risk or gain profit from declining securities. It's part of their strategy to manage investment risk and seek returns.
### Can small investors engage in short selling?
- [x] Yes, if they meet margin requirements.
- [ ] No, it is restricted to institutional investors.
- [ ] Only with SEC approval.
- [ ] Small investors must use options instead.
> **Explanation:** Small investors can engage in short selling if they meet margin requirements set by their broker. This accessibility allows a wide range of investors to take advantage of market opportunities.
Thank you for exploring the concept of going short with us. Keep learning to become a more informed and strategic investor!
