Short selling and short sales – that’s how it works "shorten"

Reap profits, even if prices fall – if you are on the winning side in every market situation, the market can hardly shock you. Short selling is often associated with hedge funds. The “hedge” in hedge funds is actually borrowed from trading with short selling, but has nothing to do with gambling, as is often assumed. In fact, the English term literally means nothing more than “hedge” and “shorting” can also be used to hedge the portfolio. But what exactly is short selling and how do you “short” correctly?

“Shorten” – earn on falling prices

Anyone who goes “short” is speculating that prices will fall on the market. Whether it’s falling stock prices, currency prices, or entire indices, investors can capitalize on any fall with the right trading vehicle. Depending on the market situation, warrants, CFDs, leverage certificates, knock-outs or futures would then be the means of choice. However, the highest level of security applies: because the expected fall in prices does not always have to actually happen. In the worst case, there is even a threat of severe losses. Therefore, a good knowledge of the market is essential for these maneuvers – or if that is not the case, at least a healthy desire to gamble.

What is short selling?

Another way to participate in falling prices is short selling. This trading variant traditionally comes from the USA and Asia and describes the short sale of securities. This means that securities are sold that are not actually in the seller’s possession at the time – they are only on loan and must be returned to the lender at a certain point in time. Anyone who sells shares, ETFs and Co. short is speculating that prices will fall in the time until they are returned. Because in this case, the short seller can buy back the paper at a lower rate. The short seller pocketed the difference between the sell and buy price as a profit.

How do I short sell?

Selling stocks that you don’t own sounds paradoxical, but it’s possible. Investors can borrow the paper they want relatively easily, from a bank, broker, fund or even from a major shareholder. There is an interest fee, which should be taken into account in advance. In addition, a fixed date is agreed in advance by which the respective papers must be returned. The short seller can then sell them on the stock exchange at the current price – he keeps the profit in the back. Now it’s getting exciting: Are prices actually falling? If so, the short seller must wait for the lowest possible price and then buy the assets, which he must return at the agreed time, at this cheaper price. After the deadline, the lender gets the securities back at the price at which they were borrowed. The short seller keeps his profit because he sold his securities at a high price and bought them back at a low price.

What if prices don’t fall?

Sometimes the markets are moody and react very differently than expected. Short sellers have to live with this risk, because it is of course possible that the prices after the short sale of the securities do not fall as expected, but may even rise. In this case, the clock continues to tick until the papers are returned. In the worst-case scenario, the short seller has to buy them back at a more expensive rate, thereby realizing a loss that can be almost unlimited.

Why short sell?

Short-selling does not always have to mean wild gambling at the same time. Sometimes an overarching downward trend is emerging on the market, such as during the bear market period from 2000 to 2002. Investors can sometimes profitably participate in such a long-term downward trend by “shorting”. The window of time until the papers are returned and thus the chance of a favorable buyback price is greater in this scenario.

Even if markets are running hot and the next correction is imminent, you can profit from this situation with short selling. And even if the overall market trend is up, short sellers can still make money on individual underlying assets that are weak against the overall trend.

In addition, investors can even secure their portfolios with short sales. When prices start falling, short stocks cushion or even offset the fall.

Short sales and their dubious reputation

In the financial world, short sales are viewed critically. They have a reputation for causing price falls when well-known investors go short, although it is not at all clear why prices should go down. In this case, cautious investors sometimes like to sell their shares as a precaution before they sleep through the price slump. But short selling can also benefit the market. Short sales, for example, help to slow down speculative exaggerations. When prices are booming and a bubble is threatening to form, investor bets on falling prices help vent some of the air in the forming bubble.

Christina Fischer, Editor

Image sources: arka38 /