What is the science behind shrot selling for investors in equities-how does it work?

Question

I know you get money when the stock goes down but what is the science behind it?

Answer 1

The main idea behind short selling is that an investor/trader believes that a certain stock (for example, XYZ) will be dropping in value in the near future. In order to capitalize on this speculation, he can earn profit by effectively "borrowing" shares of XYZ from his broker and then immediately sell at the current market price. If the trader's hunch is correct and the XYZ drops dramatically in value, he can then lock in his profit by buying the shares back and then returning them back to the broker. In other words, he is selling high and then buying back low.

Here is a numerical example, XYZ is currently worth $20.00 per share. The short seller short sells 100 shares to initially gain $2000. After awhile, XYZ drops to $10 per share. He then buys back the 100 shares, which costs him $1,000. So his total gain from short selling XYZ is $1000 ($2000 - $1000).

The risky aspect of short selling is that your gains are limited to what you originally short sold the shares, but your losses are theoretically unlimited. For example, since the lowest value that XYZ can get to is $0, the trader's maximum gain is $2000. However, since there is no theoretical limit to how high a stock can rise to (consider the extreme case of class A shares of Berkshire Hathaway, which go for over $100,000 per share), you can lose a lot if you do not close out positions that go against you.

Answer 2

shorting is harder than going long. The moves tend to be shorter and more violent, so it is quite possible to lose on the upside reversal everything you've made on the downside.

If you haven't learned to profitably trade on the long side, you probably aren't ready for short selling. Iron discipline is an absolute for short sellers.


GL

Answer 3

It's like a loan from your bank but instead of money they lend you 100 shares of Coca-Cola.

You take those shares and sell them for $1000.00 USD and a year later you buy 100 shares of Coca-Cola for $900.00 USD and you return them to the bank.