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ELI5 - Short Selling

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Investing for most people is buying stocks that they think will rise in value. If you're a fan of Apple, you buy shares in hopes of getting a piece of their expected future growth. In fancy terms, when you're optimistic about a company, you're "long" or "bullish".

When you're pessimistic about a company, you're "short" or "bearish". When investors are bearish, they can profit through a strategy known as short selling.

How Short Selling Works

There are 3 steps to short selling:

1) Borrow the shares you want to short from someone who owns the stock. This is usually an institutional investor such as a big bank. No free lunch here, you'll be charged fees for this loan.

2) Sell the borrowed shares. Pocketing the money from the sale.

3) Buy back the shares and return to lender.  The goal is to buy back at a lower price than you sold for, profiting from the spread. When the shares are returned, you're "covering" or "closing" your short position.

Example - Sally's Big Short 

Sally is not a fan of Apple. A long time Android user, she thinks Apple is overrated and overvalued. Sally is looking to profit from what she feels is their inevitable demise.

She decides to short 100 shares of Apple while it's trading at $300 a share.

1) Sally works with her broker to borrow 100 shares of Apple from an institutional investor.

2) Sally sells the borrowed shares. Pocketing $30,000 ($300 x 100 shares) in the process.

3) Sally buys back the shares to return to lender and close her short position. This is where things can go pretty well for Sally or really bad.

Sally was right

If Apple drops to $150 a share, Sally could buy back the shares for only $15,000 ($150 x 100 shares). Therefore profiting $15,000 ($30,000 - $15,000), minus fees.

The best case scenario for Sally would be Apple dropping to $0. This would allow her keep the full $30,000 she initially pocketed (minus fees) as there would be nothing for her to pay back.

Sally was oh so wrong

If Apple instead rises to say $600 a share, Sally could buy back the shares for $60,000 ($600 x 100 shares). Therefore suffering a loss of $30,000 ($60,000 - $15,000).

Losing $30,000 is a lot, but Sally's max loss from shorting is actually limitless! Apple's stock could hypothetically go up forever. This unlimited downside is the biggest risk for short sellers. 

When stocks continue to rise, short sellers face the tough decision of whether to close their position and cut their losses, or continue to hold on hoping for a decline while raking up fees and risking even greater losses. 

Conclusion 

Short selling is the polar opposite of buying stocks. When you buy stocks, your downside is capped at your initial investment but your upside is limitless. With short selling, your upside is capped but your downside is limitless. Short selling involves more fees, more stress and more risk, all for less upside. In short, don't.







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