In this article we’re going to explore , aka . Let’s get into it.

## What is shorting a stock?

Firstly, what is (aka )?

Ultimately, short selling is the reverse of buying / going long in a stock.

It’s a way of making money when the stock price *decreases.*

It involves selling an asset you do not own, and buying it back when the price decreases.

In other words, it’s the process of ‘going long’ / taking a ‘‘ in a stock (buying it), *in reverse* so that you:

- Sell first, and
- Buy back later

Put differently, a short position starts by selling a borrowed stock and then repurchasing it at a lower price to ‘pocket’ the difference as the profit.

That is, the profit from a short position is the difference between the price you sold it for and the price you bought it back for.

If it still seems counterintuitive and confusing, don’t worry. You’re not alone.

is one of the most counterintuitive, confusing phenomena of the / financial . But it does make sense, once you get your head around it.

So let’s dig a little deeper into how actually works.

**How does shorting work?**

Essentially, it’s a case of the short seller:

- Borrowing the asset from one person / investor,
- Selling it to another person / investor,
- Buying it back at a lower market price, and finally
- Returning the borrowed stock to the lender.

Let’s consider an example of a .

Imagine you have the following price forecast for Amazon Inc. (AMZN), as at January 2018:

If you look closely, you’ll see that – given this specific forecast – you expect the price of AMZN to decrease more than you expect it to increase, over the next 3 months.

Put differently, in approximately 3 months time, this forecast gives us the expectation that the market price of AMZN will either trade at $1,500 (up $200 from $1,300), or down to $1,000 (down $300 from $1,300).

In other words, our expectation looks something like this…

Given that we expect the price to decrease *more* relative to our expectation of it increasing, a short sale would make sense.

The short selling strategy / process would look something like this…

Let’s now consider the happy place of the short sell gone right.

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## Shorting stock gone right.

Such a scenario could look something like this…

We borrow 100 shares today at the of $1,300 each, and sell them immediately for $1,300 each ($130,000 in total). Let’s assume borrowing the shares attracts an interest at 3% per year, and investing the $130,000 sale proceeds in a bank deposit earns 2% interest per year. More on that in a bit.

Fast forward to 3 months later, and assume the stock price did indeed fall to $1,000.

We can now buy back 100 shares for $100,000; then return the 100 shares to our lender (plus interest), and take in a total profit of $29,675.

Not bad, indeed.

Here’s the math…

Sale proceeds – purchase cost – (interest paid – interest received).

- Sale proceeds = 100 shares at $1,300 each = $130,000
- Purchase cost = 100 shares at $1,000 each = $100,000
- Interest paid = 3% x $130,000 x (3 / 12) = $975 ## being 3% annual interest paid for 3 months (or 0.75% quarterly).
- Interest received = 2% x $130,000 x (3 / 12) = $650 ## being 2% annual interest received for 3 months (or 0.5% quarterly).

Plug in our numbers to get our profit:

$130,000 – $100,000 – ($975 – $650) = $29,675

Here’s our process again (with all the numbers):

Recall that we had 2 expectations – that the price will either be $1,500 or $1,000.

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## Shorting stock gone wrong.

Now let’s see what our position would’ve looked like if things didn’t go our way – if the stock price went up to $1,500.

This scenario would’ve seen us for the same value, $130,000. Because we would still borrow 100 shares at the current market price of $1,300 each, and sell them for the same value ($130,000).

3 months later, we’d end up having to buy back 100 shares for a total of $150,000 given a price per share of $1,500.

The interest paid and received would be the same, so we’d end up with a loss and debt equal to $20,325.

Here’s the math:

Sale proceeds – purchase cost – (interest paid – interest received).

- Sale proceeds = 100 shares at $1,300 each = $130,000
- Purchase cost = 100 shares at $1,500 each = $150,000
- Interest paid = 3% x $130,000 x (3 / 12) = $975 ## being 3% annual interest paid for 3 months (or 0.75% quarterly).
- Interest received = 2% x $130,000 x (3 / 12) = $650 ## being 2% annual interest received for 3 months (or 0.5% quarterly).

Plug in our numbers to get our loss:

$130,000 – $150,000 – ($975 – $650) = – $20,325

Here’s what our process looks like:

Now, perhaps you’re thinking – the potential loss of $20,325 is still lesser than the potential gain of $29,675. Unfortunately, this is not true – and that’s because the “potential” gain / loss is only established by our forecast.

We already know that stock prices and returns can’t really be forecasted. Not well, anyway.

Here’s the bottomline…

## Here’s why shorting is incredibly dangerous

When you ‘go long’ (buy) a stock, the maximum you can lose is your investment. And the maximum you can gain, is infinity.

That’s because stock prices can (theoretically) increase to infinity. There’s no upper bound / restriction / “maximum” stock price, so the potential for gains by buying stocks is theoretically infinite.

When you ‘short sell’ a stock however, the maximum you can gain is the price you sold it for.

That’s because you profit when the price decreases, and stock prices can only decrease to zero. There’s no such thing as a negative stock price!

Given that stock prices can go up to infinity however, taking a means that the maximum you can lose (theoretically), is infinity.

## In summary…

Alright, so we’ve learned that shorting is a way of making money when the price of an asset decreases.

It involves borrowing & selling a stock at a high price, then buying back and returning stock at a lower price, with the profit being the difference between the sell and buyback price.

The maximum gain from a short sale is equal to the price at which it was sold for.

The maximum loss for a short sale is (theoretically) as high as ∞.

With these core 4 points in place, you should never have to wonder what is shorting a stock anymore.

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