The Theory of Selling Short
Profitability is the financial motivation for investment practices. Companies successful in production and distribution offer lucrative investment opportunities in the market. Short selling, however, is an alternative way to make a profit in the market from companies, stocks or assets facing an economic downturn.
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Identification
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Short selling is the process of buying a stock, company or asset from its owner, and selling it with the intent of repurchasing it when its value decreases. The original owner may not approve of selling short, giving an investor an easy opportunity to draw an immediate profit. Therefore, the investor takes it out of the hands of the original owner, makes his profit, then sells it back to the original owner for what was paid.
The timing of the transaction is crucial to identifying an opportune time to conduct a short sale. Investors have to pay very close attention to market trends, and they have to avoid the periods of market increase. The wrong timing can render the investor into debt, however the right timing yields an easy profit for investors.
Features
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Confirmation of the ability to hand over the components of the short sale is a mandatory prerequisite of a short sale. There has to be an actual locate--an asset, stock or company that is sold, in order for the sale to be approved. There are several types of companies that are attractive candidates for a short sale on the market. Companies with a low budget but high expense, and companies with a high profit to earning ratio, are often sought for short sales. Companies that offer an unstable production, such as poor product selection and trend chasers, often find that they are unable to sustain themselves in the dynamics of the financial market. Other companies that have a weak presence and weak management, often find themselves vulnerable to competitive companies, and they oftentimes find themselves lacking in the ability to balance their finances. These companies look as if they will fluctuate in value in the market, more than the well-established businesses. Investors approach these companies with the short-selling strategy, which may give reprieve to a struggling business. It frees the business up, for a moment, but it also gives the investors an opportunity to make a profit in the interim. Once the profits are made, the property may be sold back to the original owners at a price comparable to what was paid.
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History
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The technique of short selling was not favored since its inception. Its first case was riddled with a profit for the seller and a loss for its innocent buyers. Short selling was practiced in 1609, and it was banned for the corruption of selling more of the product than actually existed. It remains a practice that is viewed with skepticism, yet savvy investors have used it with a success. In the eigteenth century, short selling was banned in England. It created another avenue of corrupt business practices, and was viewed as a method of profiting off of others downfalls. Due to its sweeping effect in the marketplace, the SEC decided to prohibit short sales for many financial companies in September, 2008. It was prohibited as a practice in other countries, as well. The overall prohibition was based on the strategic role short sales played in the disruption and downfall of the market.
Function
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There is a strategic method of conducting a short sale. The first step involves the investor confirming that the funds are available for the transaction. Shares are then borrowed. The shares are then sold by the investor, and although the short seller is not allowed to earn from the interest accrued, investors accumulate interest profits through their broker's account. Profits from selling short are also gained if the investor decides to buy the shares back, and the price has dropped. Investors can then choose to keep the shares, or sell them back to the original lender.
Warning
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Short selling is a very risky strategy. It goes against the normal profitability mode of investment, since the seller can lose more than the investment made. It can pose a credit risk for brokers as well, if the securities become undeliverable. Additionally, the risk of short selling can cause market drops in pricing, which may lead to bankruptcy for parties involved in the short sale. Its risks makes short selling a short-term endeavor that, if kept for longer periods of time, will lead to more risk of financial loss and increased maintenance expenses.
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Resources
- Photo Credit John Barker's Mortgage Blog, Info on Pre Foreclosure
