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Some time ago, the Philippine Stock Exchange (PSE) announced that they will introduce “short selling” by October 2018. The ability to do short transactions has been available abroad long ago, but in the Philippines, not a lot of people know what it is.
So what is short selling or shorting anyway? While most experienced or veteran investors know that this is how you profit from a declining stock price, not a lot of beginners know how it works so we’ll discuss the basics of short selling here.
What is Short Selling? (Trading Stocks, Currencies, etc.)
When it comes to investing in the stock market, most people know about buying stock shares of great companies, waiting until the stock price increases, and then selling the stock shares when it does. “Buy low, sell high”.
That is how you profit if you expect an investment’s price to increase.
For example, if you think “Company A” ($10 per share) will do better in the future, it’s stock price will most likely increase over time so you buy some shares so that you can sell them later. If you bought 10 shares for $100 and the stock price increases to $15 each after 6 months, you would have made a $50 profit (minus transaction fees and other costs) if you sell all your shares.
That is the most common way people profit from investing in stocks, and it’s called a “long” trade or “long position”. To do well here, you must learn how to choose great companies and investments that will grow more valuable over time. Aside from selling the shares at increased prices for a profit, you will sometimes also earn money from the dividends the company pays to stockholders.
Losing money on a Long Trade
There is a risk, by the way. If you guessed wrong (i.e. the company is actually a bad investment or it ran into several problems) and the investment’s price decreases, then you’ll lose money. For example, if Company A’s stock price decreases to $5 each and you decide to sell the 10 shares, then you’ve lost over $50 (minus transaction fees and other costs too).
What if you expect a stock’s price to decrease?
That is when you do a “short” (“short sell” or “short position”). Now what is short selling? It’s the “opposite” of the previous transaction. Instead of buying low now to sell high later, you “SELL HIGH NOW, then buy low LATER.”
Now how does that work?
Whenever you short, you borrow some shares of stock from your broker and sell them now at the current price. Then when the price decreases, you close the transaction, buy back some shares (hopefully at a lower price) and return them to your broker.
For example, if you think “Company A”’s stock price will decrease (because the company ran into some trouble, they had bad products, etc.), then you can short sell some of their stock at the current price ($10) and close it later. If you shorted 10 shares at $10 each and the stock price goes down to $5 a few months later when you decide to “close” the transaction, you sold 10 shares at $10 each and bought them for $5 each. That way, you earned a $50 profit (minus transaction fees and other costs).
Losing money on a Short Trade
The risk here is the opposite of the long transaction by the way. You’re expecting the price to decrease… but if the price INCREASES instead, then you’ve lost money. For example, by shorting 10 shares for $10 each and the price increases to $15 when you close, you sold shares for $10 and bought them for $15 so you lost $50 (minus transaction fees and other costs).
By the way, you cannot skip “closing” the trade if the price increases (you’re losing money). The broker can do a margin call or “buy in” to forcefully close the transaction and get their shares back. Another thing about shorting is if you short and the stock earns a dividend while you haven’t closed the trade, you’ll need to pay for it as well so that’s an added cost.
To get good at earning through shorting stocks (and other investments), you need to learn how to read markets well. Unlike actually investing in a company, you’re speculating or “guessing” that the stock price will decrease according to your research. It’s one thing to know if a company is doing well. It’s another to know if a company is doing badly enough that you can bet your money on its decline. If you guess wrong, you can lose a lot of money.
We’ll end the lesson here for now, and I hope this article clearly taught you the difference between buying stocks and “shorting” or short selling.
By the way, shorting is not just for stocks. It’s used for lots of things like currencies and other investments too! In any case, if you want to learn more about investing in the stock market or mutual funds, then just check out our other investing articles below!
- What are the Different Kinds of Stocks?
- 5 Tips for Understanding the Stock Market
- 10 Reasons to Start Investing in Dividend Stocks
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