Saturday, February 24, 2007
What is Shorting a Stock or Going Short?
The stock markets are funny!
You would have thought that you can sell only what you have, but in the case of stock markets you can sell something you do not have. Three questions arise: Why will someone want to sell stocks they do not own, how is this possible, and what is the catch?
Why will someone want to sell stocks they do not own? - Well, let's say you are convinced that the price of a stock (that you do not own) is going to decrease significantly over the next few months. You cannot make money with this information if you buy stocks, right? But you can make money with this information if you sell some of those stocks now at a higher price and buy them later at a lower price.
How can I sell stocks that I do not own? - This is possible because you can borrow stocks from some one else (usually a stock brokerage house) and sell them. Makes sense?
But what is the catch? Ah, this is an important point. The catch is, you need to return the stocks you borrowed to the lender (say a stock brokerage house) at some point in time. In order to return these stocks, you will need to buy them from the market. If during the period between your selling and purchase, the price had decreased considerably, then you make a profit. If on the other hand, your information was wrong and the price of the stock increases during this period, you make a loss.
You would have thought that you can sell only what you have, but in the case of stock markets you can sell something you do not have. Three questions arise: Why will someone want to sell stocks they do not own, how is this possible, and what is the catch?
Why will someone want to sell stocks they do not own? - Well, let's say you are convinced that the price of a stock (that you do not own) is going to decrease significantly over the next few months. You cannot make money with this information if you buy stocks, right? But you can make money with this information if you sell some of those stocks now at a higher price and buy them later at a lower price.
How can I sell stocks that I do not own? - This is possible because you can borrow stocks from some one else (usually a stock brokerage house) and sell them. Makes sense?
But what is the catch? Ah, this is an important point. The catch is, you need to return the stocks you borrowed to the lender (say a stock brokerage house) at some point in time. In order to return these stocks, you will need to buy them from the market. If during the period between your selling and purchase, the price had decreased considerably, then you make a profit. If on the other hand, your information was wrong and the price of the stock increases during this period, you make a loss.
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