What Is Short Selling and How Does It Work

Have you ever wondered what short selling is and what people talk about when they talk about shorting and shorting the market and going short? My name is Adrian Reid. I'm the founder of Enlightened Stock Trading. And in this video I'm going to explain what is short selling and why it's such an important trading strategy for you to understand. But before we go any further, make sure you hit the subscribe button and give this video a thumbs up so that you get notified of all of my future videos. Because I've got new trading content coming out all the time and I don't want you to miss a thing. So if you have a look at the market over a long period of time, I've got a chart here of the S&P 500 all the way back to 1995. You can see that there's obviously an upward bias in the market, right? It does tend to grow over time. Share prices do go up over time, but it is punctuated by these very large bear markets. Big pullbacks of 20 to 50% or more, even where the price drops over a couple of years or less. Now, if you're a buy and hold investor or a long only investor during these times, what's going to happen to you? Well, you're basically going to either sit around on your hands in cash waiting for the market to recover, or if you're invested, you're going to be losing money waiting for the market to recover. And it could be for years. You could be sitting around waiting to get back to your previous equity highs because a bear market could wipe 50% off the value of the share market and take several years to recover. So how do you deal with that? Well, short selling is a really great strategy to help you make money during these bear markets. Now, how does it work? Well, when you're shorting the market, what you're doing is you are selling a share that you don't currently own, expecting that it will fall in price so you can buy it back later at a lower price and make a profit. But how does that work? Because you're selling something that you don't own? Well, what you do is you go to your broker and you borrow the shares. So say you think ABC stock is going to decline in price and it's currently trading at $100 per share. So you go to your broker, you borrow ABC stock and you then sell it immediately at $100 per share. Later on, the market has fallen. Let's say it's fallen to 50%, sorry, to $50 per share. You buy it back and return those shares to your broker. You, you sold it at 100, you bought it back at 50. That $50 per share was the profit that you made. But where does the broker get the shares from? The broker doesn't just make these shares up out of thin air. They've got to come from somewhere. Well, the broker actually has arrangements with large shareholders and funds to borrow their shares in exchange for a fee. And that's called the stock borrow fee. So, so when you go into your broken account and you select sell on a share that you don't own, effectively setting up a short sell trade, the broker automatically goes to these partners that it's got relationships with, borrows those shares, loans them to you, and then you sell them. For every day that you have that position open, you have to pay a stock borrow fee to the broker. The broker then keeps some of that and gives some of it to the original beneficial owner. The, the shares. That's their fee for lending the shares to you. That's a service that they're providing for you in order for you to trade short. So it's short because you know you're short of that stock. You have borrowed it and got rid of it. You owe that stock back to the original owner. That's why it's called short selling or shorting a stock. So you make money in a bear market by borrowing a stock, selling it short at a high price, and then later on covering or buying it back at a low price and delivering it back to the broker. So then you're closing out your position at a profit. Of course, if the market goes against you, let's say you short ABC stock at $100 a share and the price jumps to $150 a share, you buy it back and deliver it back to the broker. Now you've got a $50 per share loss. So you sold at 50, you bought it 150. The difference is your profit or loss. So in this case, you lost $100 per share. Let's have a look at another example, a real example from one of my trading systems in the trader success system. This was a trade that was kicked up in late 2008 in AIG stock. And as you might be aware, in 2008, during the financial crisis, basically most of the banks, most of the insurance companies were just getting absolutely hammered. So AIG is, is one of those stocks. And it was declining from, from very big highs, way up above here. 680 on the 6. 640 or something on the right hand, left hand side of this chart. But you can see my system sold this stock short here in September at $202.25 per share. Help if I shared my screen. So AIG was shorted at $202.25 per share. And the next day the system covered this stock or bought the share back at $95.05. So here's how the trade plays out. You sold 100 shares short at $202.25. Later you bought them back. Or one day later, in fact, you bought them back at $95.05. The profit per share is the difference between those two. So in this case, $107.20. And if you sold short 100 shares, then the total profit on that trade is $10,720. So that's how shorting works. You borrow shares from your broker, you sell them on the market at a high price. Later on, hopefully you buy them back at a lower price so you've got a profit and then you return them to your broker. Now I'm doing a whole series on short selling. If you want to watch the next video in that series, if you're watching this on YouTube, click here. Watch that video. Otherwise, if you're on the blog, just scroll down. You'll see the next one. So I hope that helps. If you've got any questions on short selling, feel free to comment and I'll help you out. That's all for this video. I'm Adrian Reid. This is Enlightened Stock Trading. See you in the next one. Bye for now.

Sa.