Shorting a stock
Shorting a stock (or short selling) is a trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
How can I use short selling when investing in stocks?
- You can use it to take advantage of a market downturn. As many stock prices are positively correlated with one another, an adverse movement in one sector will sometimes cause a market-wide downward trend, like the one we saw in the March 2020 crash where equities in all sectors incurred heavy losses. If you had taken up a short position at the beginning of the March crash, you would have reaped an average of 23% returns at the start of the rally.
- If you are holding on to a portfolio of stocks, you can use short selling to hedge against the downside risk of your other long positions in the same sector. For example, if you already are holding onto Apple and Amazon's stocks, you can diversify potential downside by shorting Tesla and Microsoft's stocks. All four stocks are in the tech sector, and their stock prices will often move in the same direction. If all their stock prices rise, your gains from Apple and Amazon's stocks will cover for the losses you incurred from Tesla and Microsoft's stocks. However, if all their stock prices fall, your losses from Apple and Amazon's stocks will be covered by gains from Tesla and Microsoft's stocks.
- However, the long-term view of the market is that stock prices will only rise as global GDP will grow in the long-term, and corporations grow bigger. Given this philosophy, many long-term investors and funds will keep buying stocks regularly, thus pushing up aggregate demand for equities, and making shorting a risky long-term proposition.
Even in the short-term, short selling is an asymmetric bet heavily tilted against the "bear":
- "The market can stay irrational far longer than you can stay solvent" – cult-like behaviour can form around companies that perhaps have poor financials.
- Shorting also involves fees (overnight etc.) and interest – long-only "bulls" don't need to pay anything.
- a short seller can be forced into closing a position to meet margin calls (the margin is the collateral that the seller put down to borrow the value of the position) – a long investor has no such worries, either
- Finally, you need to time the market perfectly. If there is a bounce-back, you can be forced to close your position with heavy losses, which is precisely what happened in late-March 2020 to many investors after governments around the world bailed out their economies.
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Time of declining economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and sales.
A stimulus package is a coordinated effort by the government to increase spending and investment to "stimulate" an economy out of a downturn.
Shorting a stock
Trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
Market-capitalization-weighted index tracking the performance of the 500 largest U.S. companies