Short selling is a difficult task for beginners and many wonder: How can I sell something that I do not even own?
In this article, we explain 3 key facts and phenomena about and around short-selling.
#1 Fact: You can sell stocks without owning them
The idea of buying something is easy to understand and also to sell something that you own. But how can you sell something you do not own? The answer is relatively simple: You borrow it to sell it afterwards.
Why do people short stocks?
The answer to this question is very simple: to make money. With a short you make money by profiting from falling prices. But you can only do this if you first make the sale as a transaction and buy back later at a lower price. The result of your trade is the difference between the selling price and the buying price. If you sell at a high price and buy back at a lower price, then you will have made a profit.
Lumber Liquidators weekly June 2014 - February 2016:
#2 Fact: You can use short interest to find short candidates
A good way to look for suitable candidates for a short is short interest. If the short interest is very high, then this indicates that several institutional traders or the so-called "smart money" are in the starting blocks for falling prices. For U.S. markets, short interest for individual stocks is updated monthly via various publications, e.g. Nasdaq's short short interest page.
#3 Fact: When shorts get squeezed, the price can explode
The word short squeeze is heard again and again, but very few people know what it means. The name already reveals a lot. Traders with short positions are squeezed out of the market.
How does a short squeeze work?
If you have a short position, you bet on falling prices and rising prices lead to losses. These losses are limited in most cases by having a stop in the market. When this certain price level is reached, the short position is closed by making a purchase. This buy order leads to a further increase in the price, which in turn encourages or compels other traders to buy. Especially when a lot of traders were expecting a company to deliver poor earnings results, an outperformance of the company can convince many short traders to close their positions, meaning they are all trying to buy the stock at the same time that many people who are impressed by the company's results also want to buy the stock, often leading to massive upward price moves.
How can I learn more about short-selling?
We recently published a course on short selling and how to benefit from it: