Happy #FinanceFriday !! I hope you had a great week and plan to have a wonderful weekend. This week’s #FinanceFriday will cover Short Selling.
Normally, when we buy shares we hope the value/price rises and then sell the shares when it does rise to receive the return on our investment. However, with short selling, you sell BEFORE you buy. This option is perfect for bearish investors who believe prices will decline over time, so they want to sell now and buy later. Remember: Buy low, sell high.
I know you’re wondering, how do you sell shares before you buy them? You “borrow” them. For example, if you short sell 100 shares of a company for $10 per share then when the price drops to $8 per share, you buy those 100 shares back from the open market and return them to the lender (owner) of the shares. By selling at $10 per share and buying them later for $8 per share, you gained $2 per share or $200 from that short sell.
Seems like a foolproof plan to gain profit, right? Well as you may have learned by now, anything dealing with investing always has a risk involved. When you choose to short sell shares, you are speculating that the stock value will fall over time. If it does, then you do gain profit! However, if the stock value rises over time, you still have to buy those shares back, but now at a higher price than you sold them for; thus, you lose money.
During the short sell process, the owner/lender of the shares doesn’t notice that they have been borrowed by the short seller. The broker acts as the middleman; retrieving the shares from the lender for the short seller to sell then getting the share back to the lender when the short seller buys the shares back from the open market. If there is a dividend issued during the time the short seller is borrowing the shares, the short seller has to reimburse the lender for the lost dividend.
The short interest ratio is the ratio between the shares sold short compared to the shares outstanding in the market (shares outstanding are the shares available in the market to buy). The short interest ratio also indicates the shares short relative to the average daily shares trading. In other words, the short interest ratio is an indication of how the investors feel about the market. The higher the short interest ratio, the more bearish investors are and the more investors believe the market will fall.
Short selling is a great option if you truly believe that the value of the shares you what to short sell will decline. However, there is no way for you to know for sure that the value of the shares will indeed decline. If you’ve done your research about the valuation of the shares and the performance of the company and you strongly feel like the shares are currently overvalued, then short selling would be a reasonable option for those shares.
If you have any questions or want to add to the conversation, don’t hesitate to comment below or email me at NsideMyBox@gmail.com. I look forward to hearing from you and will see you back here next week! Happy Investing!