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Few investors have made billions using Short selling investment strategy. Especially during the different financial crises. What is it? How does it work?
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What is Short Selling
In simple terms you sell a stock earlier on a higher price and then you buy later at a lower price
A bit more technical explanation of Short Selling
Shorting a stock means borrowing a stock shares that you don’t own and then selling them to another investor.
To open a short position, a trader must have a margin account.
If the amount in the margin account falls below your margin to the broker, the broker will close the position.
Let’s take an example
You observe that a stock is highly valued and would fall in future.
So You borrow $1000 worth of stocks from your broker and sell it in the market, (you have $1000 in pocket)
Now the stock’s worth falls to $800.
You would return those borrowed shares worth $800 only (You payback $800)
You just earned $200 in profit
Why Traders do short selling?
- Traders observe that a stock is overvalued and would decline due to certain reasons.
- Little initial capital required but the scope of a huge margin.
- Some keen traders detect fraud and hope that market would realize soon.
- The shorting strategy is also used as a hedging technique in case the market falls.
The famous movie
The movie “The Big Short” is based on how few traders say the instability in the US housing market and predicted its collapse.
John Paulson, a NY hedge fund manager made $3bn by shorting subprime mortgages before the financial crisis in 2008.
But Shorting is too too too risky
- What if the stock price continues to rise?? It may take some time for the market to realize. Timing is very crucial in shorting.
- History is proof that stocks have shown an upward trend. YOU WOULD BE GOING AGAINST THE FLOW.
- There is a high risk that regulators can ban short-selling if they see a panic. Such action actually may increase the price
Famous short sellings in History
- Jesse Livermore shorted the 1929 market crash and made $100 million.
- George Soros shorted the British pound and made $1 billion.
- John Templeton shorted the Dot-Com bubble and made $80 million in weeks.
- Paul Tudor Jones made $100 million when he predicted Black Monday in 1987 through shorting
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