Markets go up – markets go down. Everyone knows that. What people don't know, however, is that money is made in both directions. One of the biggest public misconceptions is that if the markets are going down, then everyone in the market is losing money.
This couldn't be further from the truth. Short-selling allows market participants to make money – just as much of it – while it's going down as well.
"Oh but shorting is immoral, and wrong "
I've been hearing this a lot from some of the community members and Mango Readers as well. I was a bit intrigued by this notion – so I asked a few questions on why they have this idea. After a few conversations, I've come to realise that many people seem to misunderstand what Short-Selling really is.
"Most people seem to misunderstand what short-selling is"
Short-selling actually serves a crucial role in the market. And whether you believe it's immoral or not, it will really benefit you to understand how it works. Understanding Short-Selling will allow you to:
And you don't need to be a short-seller to take advantage of these things. All you need is to understand how short selling works. In this guide, I'll explain short selling – as I usually do – using a simple analogy and story.
The confusion over 'short sell' and 'short squeeze', and the debate over morals and value investing when trading cryptocurrency
John is a young, charismatic & ambitious kid. He’s also extremely well connected. News seems to get to him before anyone else. One day, John comes over to your house and asks if he could borrow your PlayStation 4. The conversation goes like this:
"My man, can I borrow your PS4? I’ll have it back to you asap"
"Uh… okay? Do you want a couple of games with that?"
"Nah, just the PS4! Thanks, mate!"
He unplugs the PS4 and strolls out of your apartment while hugging it between his arms. You scratch your head for a second, and then go back to babysitting your shitcoins. The following week, you visit John for his birthday. He turns on his dusty old PlayStation 2. Obviously, you’re surprised by this since you lent him a PS4 not too long ago.
"Hey, where’s the PS4 I lent you?!"
"Oh, that? I sold it right away"
"Don’t worry about it – I sold it for $400. I have the cash with me. I’m going to buy it back much cheaper."
"Well, I heard – from a reliable source – that the new PS5 is going to announce a surprise product launch in a couple of days! The PS4 will go down in price almost instantly!"
"Uh...Okay… You better know what you’re doing. Because you OWE me a PS4, and the way I see it – you’re short one PS4"
As you can see, that’s where the term “short” comes from in trading. It’s like at the grocery cash counter and you’re a couple pennies short. The grocery store will probably let you get away with it. In trading however, people who are “short” have borrowed that money/commodity/stock. And they need to return it.
In our scenario, John owes you a PS4 – but he doesn’t have it on him. He’s short a PS4.
A couple days later, Sony announces their new PS5. And what do you know – the price for the PS4 dips significantly on the classifieds. John buys back the PS4 for $250. But remember, he initially sold it for $400. So now, he has a $150 profit and the PS4. He returns the PS4 back to you – and everyone is happy. (Well, everyone in this story...)
So, in that scenario things worked out pretty well for John. His information checked out: Sony announced the new PS5. But.. what if they hadn’t? What if Sony announced this instead:
“Sony PlayStation 5 delayed for another two years”
Uh oh… John was expecting the price to go down on the fact that Sony was releasing the PlayStation 5. You call up John immediately:
"Hey man, did you read the news? Sony won’t be releasing the PS5 after all! How are you going to return my PS4?"
"Don’t worry, mate. I still have the cash! I’ll just buy it back!"
"Uh..alright, I guess. Just have it back to me as soon as possible. I need it this weekend"
John quickly calls up the guy to whom he sold the PS4. His name is Greg.
"Hey, I’d like to buy the PS4 back from you!"
"No problem! That’ll be $500"
"What? Market rate was $400 just yesterday"
"Yeah, but turns out everyone was waiting on the sidelines to buy the PS5. As soon as the news hit that it won’t be out for another 2 years, buyers for the PS4 flooded the market! There’s far more demand now. More demand = Higher Prices"
I don’t need an economics lesson from you, Greg. $500 it is... Just give it back to me.
Looks like things didn’t turn out so well for John in that scenario. The scenario is identical to the previous one. He borrowed your PS4 and then sold it – so he is short one PS4. He needs to return that PS4 to you at some point. John was speculating on the news going in his favour – but it went against instead. The price went up. He had to buy
Now, this is where things get really interesting. In the second scenario – John was able to buy back the PlayStation 4 at loss of $100. But things could have got far worse for John – especially if he was “following the herd”.
Let’s say Sony had announced this instead:
“Sony PlayStation 5 Cancelled Permanently! Sony will also stop making new PlayStation 4s”
Uh oh… This would mean:
People waiting patiently for the PS5 would rush in to buy the PS4
The PlayStation 4 now has a limited quantity available in the world.
John hears the news a bit too late because he was out getting drunk with his buddies. As soon as hears, he calls up Henry:
"Hey man, I need a PlayStation 4 – do you have one on hand?"
"Yeap, but I have only 3 left. They are selling like hotcakes!"
"Okay I’ll take one! How much?"
"Wait, what? That’s too much."
"Sorry man, those are the offers I’m getting at the moment"
I’ll give you $550
Alright, If I don’t make a sale in the next hour, you can have it for that… oh wait.. I have another call, brb...
*Henry puts John on hold for a minute and comes back..*
Hey man, I just made a sale for $600. And I got two more offers at $700 each. These are the last two I have left… do you want one or not?
Wait, now it’s $700?
Yeap.. and it seems like it’s going to keep going up.
You gotta be KIDDING ME! Ughh.. Fine I’ll take it.
Damn – John just took a loss of $300. What happened there? Well, it seems like John found himself in a “squeeze”. Ever hear that phrase before? You find yourself in a squeeze when you know that you’re getting a shitty deal – but you have to take it anyway.
Air Canada once did that to me because of a spelling error on my flight ticket: “Sorry sir, your flight leaves in 30 mins, and we need to rebook with the right name. Unless you pay the $250 rebooking fee you will miss your flight completely” I gritted my teeth, paid the fee and swore never to fly with them again. I was in a squeeze.
John found himself in a similar situation – he was forced to pay $700 for the PS4 or he faced taking worse losses. But how exactly did that happen? Let’s break it down:
It seems like John wasn’t the only one betting on the Sony PlayStation 5 news. There were several others that were betting on the same outcome. They had ALL borrowed a PlayStation 4 and sold right away. Of course, they knew that they had to return it back – but all of them were expecting the price to move down instead of up.
As soon as the bad news came, there was a rush to buy back the PlayStation 4.
Also, since the PlayStation 4 became a limited edition product, many other people stepped in to buy as well. The price moved up suddenly!
People – like John – who were late to hear the news, were faced with a situation where they had to buy the PS4 at ridiculous rates. This caused even more upward pressure on the price of a PS4. As more and more people bought the PS4 simply to return it to their rightful owners, the price skyrocketed.
Short-selling may seem like an attractive option – especially in a market that is trending downward. But it may not be a good idea for everyone. A key difference between short-selling and "buying long" is the risk involved. If you invest in an item/stock and decide to hold it for a long period, at most your risk your investment going down to 0$. There is a floor-price that the item can hit After all, a PS4 could never cost "–50$". That would imply that Sony would have to pay you to take the PS4 of their hands.
However, if you short-sell a PS4 then you are relying on the price going down. Your risk , however, is unlimited if the price goes up. Why? Because there is no ceiling to the upward movement on the price. For all you know, the price for the rare PS4 could hit $10,000. Consider the following scenarios:
Scenario 1: Joe buys a PS4 for $400 speculating that the price will go up in price. (he's 'long')
Unfortunately for Joe, Sony announces that they will be releasing the PlayStation 5 and will stop supporting the PlayStation 4. Joe is out on vacation during the announcement and the price of the PlayStation 4 dips all the way to $0.
Joe comes home and realises that his investment went to crap. He was unlucky that the announcement occurred while he was away since he may have sold his investment quickly. He's disappointed, he lost $400. But it's no big-deal, life will go on as usual. Hell, at least he still has the PS4 to play some games on.
Scenario 2: Joe borrows a PS4 and sells it immediately for $400 – because he expects the price to go down (he is 'short' )
Remember, Joe borrowed the PS4 – so he has to return it eventually. Unfortunately for Joe, Sony announces that PlayStation 5 has been cancelled and the PS4 will be limited in supply. Joe is out on vacation during this announcement, and the price begins to skyrocket all the way to $10,000.
Joe comes home and realises that he has to now buy back the PlayStation 4 for a $9600 loss. Joe doesn't want to take the loss, but he's afraid that if he doesn't buyback the PS4 now then it may go up to $20,000 in the future. Joe has to use his student loan to buy back the PS4. Joes life may have just taken a serious set-back.
As you can see, in the first scenario Joe found himself in an unlucky situation. The announcement against his "long investment" occurred while he was on vacation. But his losses were limited to the cost of his initial purchase – $400
In the second scenario, however, Joe being on vacation during the announcement hurt him dearly. By the time he reached home, his losses had already racked up to $9600. If he didn't buy the PS4 back soon, he faced it going up in price even further!
That being said, risk in short-selling can be managed – but it shouldn't be taken lightly. So thread carefully, grasshoppers.
The important thing to note is that people who Short Sell, have to eventually “buy back” what they sold. Essentially, they turn into buyers. If the price moves against them, they turn into buyers at even higher prices – which adds momentum to the upward pressure in the market.
Even if the price moves in their favour (i.e the price moves down), they will eventually want to “buy back” to take their profits. This is important – because someone else gets to sell to them. Essentially, their “buys” at the lower price adds liquidity to the market. Shorting allows people to “buy” in bad market conditions with confidence. In market conditions where everyone is too scared to buy, shorters are sometimes the only ones who add friction to the downward pressure. Without this we may see drastic swings in price.
Economists widely agree that short selling is an important part of the price discovery process. However, manipulation and corruption (as with many things) makes a lot of people skeptical.
Either way, I hope this post helped you grasp the basics of Short Selling and The Short Squeeze. If you have more specific questions – ask below! Email! Join me on TG!
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