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How does that work? Short selling

Have you ever come across the term short selling?


The topic has already played a role in well-known films such as "The Big Short" and the large hedge funds have also often been in the spotlight due to their short-selling activities. A prominent case in the recent past is, for example, the GameStop Reddit story.

In 2021, the GameStop share recorded an impressive price increase. The share price of the US retail chain GameStop rose from just under 20 dollars at the beginning of 2021 to around 480 dollars in the meantime, which attracted great media attention worldwide. The company's market capitalisation reached over 20 billion dollars.

Before this spectacular rise, several hedge funds had bet on the fall of the GameStop share and invested large sums with short sales. However, when the stock shot up, these funds suffered losses in the billions.

This dramatic price increase was triggered by the community r/wallstreetbets, a subforum of the social network Reddit. Here, numerous small investors joined together and decided to buy the GameStop share. Over time, this phenomenon spread to shares of other companies, especially those that were also heavily short sold. A prominent example was the US cinema operator AMC Entertainment.

On 28 January, a drastic cut occurred as a result of a lack of collateral deposited with clearing houses. Several brokers, including Robinhood, TD Ameritrade/Charles Schwab, Interactive Brokers and Webull on the US market and Trade Republic on the German market, temporarily stopped the possibility to buy GameStop shares. This measure met with widespread criticism and caused controversial discussions.

One could write much more about this (you will certainly find some exciting articles on this quickly if you are interested). I would rather like to briefly explain to you what the short trade is all about.


The functioning of short selling

In short selling, an investor bets that the price of a certain share will fall in the future. The way to do this is fundamentally different from a conventional share purchase. To take a short position, the investor first borrows the shares from a broker. These borrowed shares are then immediately sold on the market.

It is important to mention here that the broker requires a certain amount of capital or other securities as collateral. This collateral serves to cushion possible losses. This is because, unlike when buying shares, where the possible loss is limited to the stake, in short selling there is theoretically no limit to possible losses. If the share price rises, the investor must buy back the shares at a higher price to return them to the original owner.


Advantages of short selling


  1. Profit opportunity on falling prices: The most obvious advantage of short selling is the possibility of also profiting from falling prices. This opens up an additional source of income for investors and expands their options for action in various market conditions.

  2. Hedging against losses: Short selling can serve as a hedging strategy. If an investor already has a position in a particular security and fears that the price might fall, he can take a short position to offset possible losses.

  3. Detecting market inefficiencies: Sometimes there are companies whose share prices are overvalued. By short selling, investors can uncover such overvaluations and possibly profit from the correction of the share price.

  4. Diversification of the investment strategy: Short selling allows investors to diversify their investment strategy. Instead of betting only on rising prices, they can also profit from falling prices.


The risk of short selling

The risks of short selling should not be underestimated. Since there is no limit to possible losses, a rise in the price of the borrowed shares can lead to considerable financial losses.

Therefore, it is possible to lose more money than was originally invested. For this reason, it is crucial that an investor taking a short position has sufficient capital to cover possible losses.

It is important to know that one can never predict the course of a share price with certainty. Even if a company is obviously facing major problems and one is convinced of a negative price trend, various factors can lead to different results. For example, an investor could suddenly help such a financially weak company, so that it suddenly has much better prospects.

However, if you had previously bet on the opposite by going short, you would suddenly have to accept losses.

Consequently, there is always a portion of uncertainty and luck / bad luck involved.


Conclusion

Short-selling requires a willingness to take risks and a high degree of expertise as well as, ideally, extensive information about current market events.

Thus, in my opinion, it should only be carried out by experienced investors ( ideally professionals) who can both assess and bear the risks and have the possibility of extensive research.

As a private investor, on the other hand, it is rather a very risky speculation and should be enjoyed with caution.

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