There's more to "short selling" than meets the eye. In this edition of Investing 101, we take a look at the basics of shorting, what it is, how it works and who might do it. To help us along, we brought in Tim Smith, senior vice president at Sungard's Astec Analytics, a market data firm specializing in securities lending and borrowing.
1) What is Short Selling?
"It's the opposite of long buying," Smith says in the attached video, explaining that when people buy securities, they think the price may go up. But when they sell a security short, he says "they do that because they think the price may go down." On Wall Street, there are several different iterations of shorting, but they all essentially mean the same thing; that a stock or index is overpriced and expected to go down in value. "It's another investment management technique,'' Smith says.
2) Who Should Sell Short?
While this practice of bearish bets is open to anyone, Smith says it is "really a game best left to the pros" simply because the risks surrounding shorting can be huge. "The argument goes that the downside for short selling is infinite," Smith points out, "and by that I mean, if you think the price of a share is going to go down and you put on a short position, the price could actually go up, and it could go up to infinity." For example, if you buy a $20 stock and it just goes completely out of business, the most you could loose by being long - and wrong - is $20. The flip-side of this is if you are short a stock at $20, the most you could make is $20 if you were right and that stock indeed went zero. But the catch, or mismatch, is if you're short - and wrong - that $20 stock could, theoretically, go to $1 million or more, so your ultimate exposure or risk is infinite.
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