People often say, ‘stock markets are down, I’m waiting for them to go up,’ when what they mean is that they’ve got a little extra cash they don’t know what to do with. Ideally, it would be best to focus on solid long-term, low-risk investments that can generate the highest yielding returns with the minimal invested funds. But, reality tends to be, as Thomas Sowell has pointed out, essentially tragic. It’s as if, just when you’re starting to make money from a stock you own, the bears decide to punish you by sending you stock tumbling deep into the red. Something many people tend to overlook is the equally interesting chance of investing in stocks – just the other way round, which is known as short selling a potential loss in a stock’s future value. This form of trading is regularly associated with the hedging strategy, as it can be used to reduce market risk under special circumstances. Below is an explanation of the types of activities included in each of these terms.
To short sell (or ‘going short’) is the practice of selling financial instrument(s) which are ‘borrowed’, and subsequently repurchasing them (‘covering’ a short position) at a lower price. In the event of an interim price decline, the short seller profits, since the cost of repurchase is less than the proceeds received upon the initial sale position. Conversely, the short position closes out at a loss if the price of a shorted instrument rises prior to the repurchase. The difference between the prices is referred to as the bid-ask spread, bid-offer spread or simply buy-sell. A spread is essentially a type of commission that denotes the borrowing process, and its implication for the trader. Here’s an example: Dan is a day trader. He decided to short sell stock ABC by opening a ‘Sell’ position at $100, with the expectation that ABC will go lose value in the near future. Once the stock’s price touches $88, Dan decided to cover his position, i.e. ‘Buy’ it back. His commission is included in the initial difference between ABC’s Buy and Sell prices. Dan’s profit off of ABC stock is $12 – despite never really owning the stock.
To simplify, the key players involved in this ‘unusual’ trading activity are:
The Lender; an owner of financial instrument(s) who is willing to short sell them on the market.
The Borrower; a purchaser of financial instrument(s) who is taking position(s) in the market for the purpose of profiting from price changes.
The Broker; an individual person/company who arranges the transactions between the Lender and Borrower for a price difference (=commission) when the deal is executed. As stated, this commission is generally referred to as the bid-ask spread.
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