To hedge

The first reason is to hedge your investment. A basic example of this would be protecting your long position in a company from market-wide price changes by short-selling the stock of a different company in the same market. This means that if a market-wide price decrease of shares occurs due to some negative developments in the market you will lose a lot less money (maybe even none) with a short position protecting your long position than if you only had the long position. Many hedge funds (link to hedge funds) as well as some mutual funds (link) employ this strategy as a means of minimizing the risk of their investments.

To speculate

The second reason that drives investors to short-sell is based on speculation. When some investors believe that a certain stock is going to decrease in price they short-sell it in order to make a profit later on when the decrease in price occurs.

Short selling stocks on speculation can be very rewarding in terms of the return on your investment (ROI) but it is also a very risky endeavor. Shares can drop very quickly in price in reaction to negative news or various other developments – good for short selling. But they are also capable of rising in price just as quickly. If you shorted a stock that begins to rise in price then you stand to potentially lose the money you invested if you do not close your position in time. The reason for this is simple. Almost all short positions have a ‘safety mechanism’ where once the price of a stock rises to a certain point your position will be automatically closed for you and you will lose all of your investment – this is done in order to prevent you from losing more than you invested.

One of the many reasons that can lead to rapid price increase of a stock is when there are many short sellers of a particular stock who are looking to ‘insure’ their short position by opening a long position – this creates demand for the stock and causes its price to rise – this is formally known as a short squeeze.

If you are an inexperienced investor it is best to use short selling as a hedging technique to minimize the risk of your long positions. If however you are looking for greater profits and can handle a hefty amount of risk then this is one of the most ideal speculative investing techniques around.

Subjects keywords: Short selling, Short selling stocks, hedge investments, short-sell speculation. All information about short selling.