Monday, October 06, 2008

What is short selling?

Short selling is what investors do if they expect the value of a stock to decline and want to profit from it. It works this way: The investor borrows shares of a company, then sells them at market value. After a short period of time, the investor buys them back and returns them to the entity that loaned him the shares. If the stock price goes down far enough, the investor makes a profit.

So let's say I hear about WalSoft's new gaming console. I read the reviews and I think its a dud. I think that the holiday sales will be so awful that it will hurt the stock price. So the day before Thanksgiving I borrow 100 shares of WalSoft stock from an investment firm. I agree to return them within 10 days. I sell them all at $50 a share.
So I have $5000. The following Monday, the evening news features a story about WalSoft consoles catching fire when plugged in. On Tuesday, WalSoft drops to $40 a share. I figure that the price won't get much lower, so I buy 100 shares at that price. I give the shares back to the investment firm, pay them a $500 fee, and keep the $500 that is left over.

This is something that happens a lot when the stock market is going down. But it is not the cause of the disease, merely the symptom. If there is short selling going on, we don't need to stop it but instead figure out why it's going on. Investors sell short when they think a stock is overvalued.

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