People typically purchase stocks in a company for two reasons:
- to make money from an increase in stock price over time
- to make money from dividends
However, there is a third way to make money with stocks… a very risky way called ‘short selling’.
What is Short Selling Stocks In Simple Terms?
A ‘short’ as it is called in the financial industry is a bet against a companies stock.
To short a stock, you ‘borrow’ shares from someone with a promise to give them back at a future date. Often this is just a few days or weeks but could be a longer time period.
You immediately sell the borrowed stock and pocket the cash. When you have to pay the stock back, you HOPE the stock has gone down in value so you can buy a replacement for a lower price.
For example if you borrow a stock for $100 and sell it today, then tomorrow the price of that stock drops to $90 and you buy it back, you just made $10!
How Can Short Selling Be Good For Markets?
Obviously if the short seller is right and he profits from his risk, he is happy, but what about the market and society at large? How can a companies loss in stock price be a good thing?
Well, you will be shocked to find that executives and management down play the negatives of their companies and hype the positives. This means that if it were only up to companies and their employees to tell you what is happening, you would likely think that all companies are doing great and their future is bright.
This is where short sellers help the market.
Short sellers are always investigating. They ignore the corporate hype and look at real numbers, the economy at large, pending regulations, possible mergers, new technologies, changing management and other factors that might hurt a companies prospects.
Targets of short sellers often claim they are manipulative speculators that bring instability to the market but others see short sellers as the only real truth tellers.
A short seller isn’t just hyping the negative, they are putting their money, often very large amounts of money, at risk.
Take a look at this clip from “The Big Short” explaining how some short sellers correctly predicted the 2008 world financial crisis and made giant money:
… and for fun watch this clip on what actually happened to the financial industry after the 2008 collapse: