Definitions in personal finance and investment: Short sale

Definitions in personal finance and investment: Short sale

We explain a stock market investment practice that has been making the news recently: short sales.

Short selling is an activity that is directly related to speculation. Speculation is an investment practice that aims for higher returns based on educated (or informed) choices on how an invetsment will perform in the near future.

Why it happens

Short sales take place most often under certain circumstances: just before corporations’ quarterly reports come out, or when there are specific events taking place (storms, wars, product recalls…) that indicate that the value of the shares of a certain company or companies is about to drop significantly.

How it happens

Short selling consists of borrowing shares of a company, the value of which the borrower believes is about to go down. The borrower sells the shares and -if he/she got it right- once the share’s value drops, they buy the same number of shares back (for a lower price); at that point he/she returns the shares to their lender, and pockets the difference between what he/she sold them for, and what they paid for them later.

Doesn’t it sound like something difficult, not worth the effort?

An example

Here’s an example that shows just how well it works:

investment practice - shor sale example

Anna made over $5 million on stock she never owned.

A quick buck

Now, when we take into account that brokers perform dozens of these types of transactions each day, it becomes very clear why this type of activity takes place.

Not just that, it’s considered a normal practice for companies, mutual and private (hedge) funds to manage risk on their investments. For example, if a mutual fund suspects that one of their investments is about to plummet, it can lend out shares of that investment for short-selling to make up some of the future losses. In Ana’s example, ABC brokerage made $361,205 in just 10 days. Not bad for 10 days of waiting, is it?

The risks

There are inherent risks to this investment practice. Those lending the shares out of their portfolios run the risk that they might not be returned, in which case the lender will be responsible for replacing them to the original portfolio. Additionally, the borrower runs the risk that the shares will not drop in price, so that the short sale repurchase will end up costing more than the original sale, and they will have to return the stock at a higher price, plus the commission and interest.

Nonetheless, knowing to read the market signs and companies’ performance make short selling a highly lucrative activity. It’s at the heart of stock market speculation.

  • This field is for validation purposes and should be left unchanged.