Short Selling - The need & the mechanism
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Short Selling - The need & the mechanism

by Admin 6. September 2016 04:27

 A fundamentally sound stock continues to rise as more and more people invest into it. Then the ascent is stalled temporarily as some start booking profits. The stock price comes down slightly as happens. Then suddenly the price of the stock begins to rise once again, and the stock has another big rally. This process repeatedly continues as the stock stalls temporarily and then moves on to another great rally. This is most common for a stock which is fundamentally promising and the market keeps bestowing it's faith into the stock.

But not all stocks are fundamentally sound, and not all companies and sectors grow at the same rate and proportion. What happens to a fundamentally weak stock? They keep making highs only to tank down. The upward move is stopped short, and the downward move seems never to stop.

The most common terms used in the markets to define investor categories are the bulls and the bears. The bulls are the driving forces behind a stock ascent and the bears are the driving forces behind the descent of a stock. In other words, the price of a stock continues to rise if the bulls are in control and continues to fall when the bears take over.

Stocks continue to rally so long as the bulls see a potential in it and once the stock stops exhibiting any further potential, the bulls begin to book profits. The bears take this opportunity to start selling the stock with the bulls and this added selling pressure forces the stock to crumble and the price starts dropping drastically. The bulls are out of the race and defeated and the bears take control of the stock making it drop further and further.

But how do the bears sell the stock when they haven't bought it first? And if they had bought it at lower level to sell it would they not be classified as the bulls who were booking profits?

The concept of short selling is very perplexing to many and requires some understanding. When an investor sells a stock without actually owning it, the mechanism is termed as short selling. The investor simply takes a position with his broker to sell the stock high only to buy it at a lower price later. In other words, he is borrowing the stock from his broker and selling it at a higher price only to buy it when the price comes down and settles the difference with his broker. When the price comes down, the investor buys the shares from the market at that lower price and returns it to the broker thus keeping the profit and allowing the broker to own the stock at that low price. If the price does not come down and rises beyond his selling price, the investor then buys the stock
at the higher price and after settling the loss, returns the stock to his broker at the original sell price. It is a win-win situation for the broker as besides earning huge commissions, he has the advantage of getting the stock at a lower price at a profit or higher price at his cost.

After the introduction of the derivatives segment into the markets, short selling has become a common practice with traders and investors. It allows them to take a position either long or short and take advantage of price movements in both the directions of the market.

The opposing forces of the bears and bulls keep the market in constant motion and allows a certain level of balance to prevail. If there were no short selling, the bulls would constantly dominate and when they finally did decide to book profits the damage done to the stock and the market as a whole would be far more devastating.

Many consider short selling as an evil which destroys the value of investments. But from the above, it becomes very clear how important short selling is. An evil it may be, but an extremely necessary one. It allows democracy to prevail the markets at all times and coherently dismisses any anarchy that might shape up and destroy the very fabric of the market.

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