What is short selling? Warren Buffett’s view on short selling

BlogAugust 18, 2021

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Have you ever heard of the term short selling? Do you know how to make profits even when the market goes down. The following article will help you understand what short selling is and the characteristics to keep in mind.

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1.What is Short Selling ?

When an investor goes long on an investment, it means she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn’t own. More specifically, a short sale is the sale of a security that isn’t owned by the seller, but that is promised to be delivered. That may sound confusing, but it’s actually a simple concept. Here’s the idea: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage’s own inventory, from another one of the firm’s customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must “close” the short by buying back the same number of shares (called “covering”) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can’t sell what they don’t have, and so yours will either have to come up with new shares to borrow, or you’ll have to cover. This is known as being “called away.” It doesn’t happen often, but is possible if many investors are selling a particular security short.

Since you don’t own the stock (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you’ll owe twice the number of shares at half the price.

Probably the most famous example of this was when George Soros “broke the Bank of England” in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion.

2. Features of short selling

Unlike when you hold a stock and wait for the price to go up, because you only have one risk that the price will fall and the biggest is when the price goes to zero and you only lose an amount of money at the time of purchase. While short selling, you can lose more because the price can go up forever without limit.

Short selling not only helps investors increase profits from the downward direction of the price, but it also helps increase market liquidity. Because when investors do not have shares, they can still borrow shares to sell. Trading volume will increase because at this time, the market operates in two directions, up and down, which makes the market liquidity increase and makes it more difficult for stocks to be priced.

The nature is more complicated than buying ordinary stocks, the big profit comes with high risk. Therefore, short selling can only take place in developed stock markets and is limited to large stocks with high liquidity.

Points to pay attention to when doing short selling:

  • There is no limit to how much you lose if the price continues to rise.
  • Short selling securities always involves market risk, for example when the price goes according to your prediction but suddenly changes direction will cause a loss.
  • When executing a short order, it is necessary to pay attention to taxes and transaction fees to make profits more efficiently.
  • Short selling should be for experienced investors who understand the market, inexperienced people should not participate.
  • The cost of borrowing to buy and sell stocks will affect your profits, so you need to choose good, liquid stocks to limit financial loss.

3. How to short selling ?

In the traditional form of short selling, traders borrow stocks that they do not own (usually through the stock exchange where the trader opens an account). Then, sell these shares to the market at a price below the market price. A trader’s goal when shorting securities is to then buy back those shares at a lower price, and then return the borrowed shares. Then, the trader’s profit is from the difference between the original selling price of the shares and the cost of buying them back.

How to short sell

Since the advent of CFDs (Contracts for Difference), short selling has become a lot easier because it allows traders to speculate on the ups and downs of the market without having to own any assets. base product.

Instead of investing in stocks in the traditional way, traders profit from the difference between the opening and closing prices of the stock, or the trading instrument they are using. Compared to other trading instruments, traders can easily enter and exit trades when short selling. This is one of the reasons why short selling securities via CFDs has become so popular.

4. Warren Buffett’s view of short selling

Famous investor – billionaire Warren Buffett is famous for having a long-term view when it comes to investing. He prefers stocks that are undervalued to stocks that have skyrocketed because of media attention and hype.

He does not deny short selling can be profitable. However, he did not do that, because it only brought a limited profit but the possibility of loss was unlimited.

‘It’s fascinating’

At Berkshire Hathaway’s annual meeting in 2001, he said short selling had “ruined a lot of people. “It can burn you out.”

“It’s absolutely fascinating,” he continued. “You often see stocks that are suddenly overvalued rather than stocks that are unusually undervalued… So you think making money short selling is delicious. And all I can say is it’s not for me.”

‘It’s really harsh’

One of the main problems, Buffett says, is that short sellers are relying entirely on powerful and influential parties to inflate stocks.

“It’s a very, very difficult thing to do because you have to deal with unpredictable losses and in fact people who overvalue stocks often straddle the thin line between advertiser and scammer,” he said. shared in the 2001 meeting.

According to Buffett, short sellers can run out of money before the stock bulls run out of ways to keep prices up.

“It was really harsh,” he said. “In my experience, making money in the long run is a lot easier.”

‘Simply stupid’

Buffett also reacted strongly to the question of “leverage,” an essential element of short selling because stocks need to be borrowed first to short.

In a Q&A with the University of Florida Business School in 1998, Buffett commented on the collapse of Long Term Capital Management (LTCM) at that time, a famous hedge fund that was once very successful and famous as one of the founders who won the Nobel Prize.

The fund had collapsed weeks earlier, in part because it had operated with too much leverage in investing in risky foreign currencies and volatile bonds.

“To make money that they didn’t have and didn’t need, they risked what they had and needed,” Buffett told the audience. “That was stupid. Simply stupid. Regardless of your IQ, it is pointless if you risk something important for something unimportant. “

In short, Short Selling will help you make quick, efficient profits in case you are right. In case you are wrong, you should have a reasonable stop loss strategy to preserve your money. Hopefully the article has helped readers understand a bit about short selling and related notes. Investki wishes you successful trading!

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