Lecture 44: Trading 3

Short Selling Overview

Definition: Short selling is the act of selling borrowed stock to repurchase it later at a lower price, typically by investors who believe a stock is overvalued.

Process:

1. Borrowing Stock: Shares are borrowed through a brokerage.

2. Selling: The investor sells the borrowed stock at market price.

3. Covering the Position: The investor repurchases the shares at a lower price to return them to the lender, netting profit or loss.

Profitability:

• Limited Upside: Maximum profit occurs if the stock price drops to zero.

• Unlimited Downside: Potential losses can be infinite as stock prices can rise indefinitely.

Key Factors:

• Dividends: Short sellers pay dividends to stock owners.

• Margin Requirements: Requires a margin account, impacting net profit due to interest payments.

Historical Context: Short selling has faced criticism, especially during downturns, but is important for market corrections and accountability, as shown by incidents like the Care.com exposure.

Example Trade:

• Sell 1,000 shares at $80 ($80,000); if bought back at $70 ($70,000), profit is $10,000 (25% ROI).

• Risks of margin calls arise if stock price exceeds maintenance margins.

Conclusion: Short selling is a high-risk strategy with the potential for unlimited losses but also plays a key role in market efficiency by addressing overvalued assets.