Short Selling : Making Money When The Market is Falling

Before we get into the topic at hand lets figure out how one makes money in the stock exchange. Suppose I want to make some money in the stock market, I study the listed companies a bit, and figure out which ones are going to rise and which ones are going to fall (basically speculate based on the data available and my knowledge). Now I buy the ones that I feel will increase in value and sell them on a later date when they are costlier. Buy low sell high, easy money but let's take a step back and look at the stocks that we feel will fall.

If our speculation is right these stocks will be worth less in the future than they are now, but how do we capitalize on this knowledge? We do so by short selling the stock. In short selling the investor borrows stocks and sells them in the market and on a later date, when the price has decreased, he buys them back. Buy low sell high, well perhaps sell high buy low in this case.

However short selling has its own drawbacks, for a particular short sell the loss could be potentially infinite as the price of the security could rise to infinity but if short selling is not carefully regulated it could take a normal market dip and convert it into a crash or if a lot of investors or hedge funds decide to short a particular company's stock they could make it go bankrupt. Also if a company pays dividends during the period of the short sale then the short seller will have to bear that cost as well and pay his broker an amount equal to the dividend.

Short Squeeze

A short squeeze happens when a stock begins to rise, and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions. The most recent example of a short squeeze was GameStop Corp. Several hedge funds and large investors had large short positions on the stock and when a large group of retail traders on Reddit decided to drive up the stock's price it forced the short sellers to cover their short positions for substantial losses and thus creating even more demand for the stock making its price sky rocket.