Why Short Selling Stocks
A short sale transaction consists of borrowing shares from a broker and selling them on the market in the hope that the share price will decrease and you’ll be able to buy them back at a lower price. A trader who has a short position in a stock will be severely affected by a large price increase because the losses become larger as the price of the underlying asset increases. The reason why the short seller sustains such large losses is that he/she does have to return the borrowed shares to the lender at some point, and when that happens, the short seller is obligated to buy the asset at the market price, which is currently higher than where the short seller initially sold.
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Why people short-sell
In the same way that prices can rise, they can fall. Short-selling allows you to trade on a market no matter which direction it is heading. Reasons for short-selling include:
To profit in a bearish market
Short-selling provides a way to speculate if you think a market’s value is going to decline. This allows you to add value to your portfolio even in a bear market. Without short-selling, it can be very difficult to make money from a downbeat market.
Sometimes economic events or published financial problems can lead to a decline in the value of a company. Short-sellers tend to look out for these fluctuations in the market, hoping to make a profit as the price dips.
To protect another investment or portfolio
If you hold a number of long positions, you may choose to protect them with short positions. This is known as hedging.
For example, if you own a selection of stocks from the FTSE 100, you might use a derivative contract to hold a short position on the FTSE index as a whole, in case of adverse movements against your portfolio.
The benefit of hedging is that it allows you to minimise your portfolio risk – just like taking out an insurance policy on your house or car. Hedging is different from speculation, as the intention is to reduce risk rather than increase it.
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