Short selling is a technique used in financial markets that bets on an instrument’s price falling. It can be a complicated subject for new investors to grasp. After all, how is it possible for you to make money if a stock is losing value? And if this is the case, then who loses in short selling?
Bulls are the losers in a short sale transaction. By bulls–we mean any person who has an optimistic outlook on the price forecast of a stock. More than anyone, bulls will be hurt by the downward price pressure that short selling creates.
A stock’s price has to go up or go down, and short selling is a type of contrarian trade that allows bears–those who have a pessimistic view of a stock’s price potential–to profit from imminent price drops. If this is still confusing, keep reading for a detailed breakdown of who loses in short selling!
Who are the Losers in a Short Sale Transaction?
The losers in a short sale transaction are the bulls or those traders who believe that a stock’s price will trend in a positive direction over time.
Bulls can be divided into a couple of categories:
- Long-term bulls – this group represents the majority of stockholders. Otherwise known as the buy-and-hold crowd, these are the investors that buy a stock at a given price and believe that its share price will continue to appreciate over time as the business matures and its market develops
- Short-term bulls – consisting largely of the day trading crowd, this group of investors believe that the micro-climate for a given stock is ideal for a quick surge in price. Therefore, they buy shares of the stock and look to quickly sell and capture the profits once the price appreciates
Although short sellers hurt both long-term and short-term bulls, they are particularly problematic for short-term bulls. Short-term traders do not give the market time to turn itself around, they will usually have to exit their short-term trade at a loss if the short-selling momentum causes their trade to reach its stop-loss price.
While long-term bulls can generally survive a short-selling barrage, long-term bulls are far from guaranteed to be profitable. Too much short selling can cause panic surrounding the stock, and bulls can turn to bears in such a climate, selling their position before the bleeding gets any worse. This causes further downward price pressure that tests the resolve of any remaining bulls.
Who are the Winners in a Short Sale Transaction?
The winners in a short sale transaction are bears. These are the traders who have a pessimistic view of a stock’s future price.
Generally, only short-term bears are active participants in the market. And to be honest, “short-term bear” and “short seller” are essentially the same type of trader.
So, other short sellers win in the wake of a short sale transaction. These short sales put continued downward pressure on the stock’s price. When the stock price falls sufficiently low, then the short sellers can buy back their borrowed shares at a deep discount, returning them to the lender and pocketing the cash difference.
A long-term bear, or someone who has a long-term pessimistic outlook on the stock’s price, is not someone who generally participates in the market. If you are a long-term bear, you will typically just avoid the stock like the plague. There is really no benefit to buying a stock and holding it long-term while waiting for the price to drop.
Sure, you could enter a long-term short. But remember, you will be paying interest on your margin account with your brokerage. A margin account is a type of account required by the Federal Trade Commission for borrowing stocks to short. Unless you are nearly certain that a stock price is prepared to fall precipitously over time, the interest paid will make this an expensive proposition.
How Short Sellers Benefit from a Stock Price Dropping?
Short sellers benefit from a stock price dropping because, well, that is the name of the game in short selling. Short sellers are people who believe that a stock’s price is destined for a dive, so when it happens, they stand to profit.
The process for how short sellers profit from a price drop goes something like this:
- A bear identifies a stock that he or she believes is overpriced and due for a fall
- They “borrow” a number of stocks from their broker via a margin account, with the promise to return the borrowed shares at a later date
- The bear sells the borrowed shares at the elevated market price, keeping the cash proceeds to repurchase the shares at a later date
- Due to the influx of shares introduced to the market, the economic laws of supply and demand put downward price pressure on the stock
- If short sellers’ thinking is correct, the selling momentum will cause the stock price to take a deep dive in a short period of time, allowing them to repurchase the full allotment of borrowed shares at a deep discount
- They then return the borrowed shares to the lender and keep the cash difference from the revenue generated from the earlier sale, resulting in a successful short trade
As the old saying goes: “Stock price goes up the stairs and down the elevator.” Correctly timing a short trade can allow short sellers to capture a huge profit. This can happen in a matter of days and allows them to avoid paying much interest on their margin account.
The Bottom Line: Losers and Winners in a Short Sale
During short sale transactions, the bulls are the crowd that is going to lose. The downward price pressure created by short trades hurts their optimistic outlook. While buy-and-hold bulls don’t like short-selling activity, it is short-term bulls who are particularly crippled by a barrage of shorting.
On the flip side, the bears love short selling. This is because the downward price pressure created by a short trade helps fulfill their prediction that the price is going to drop over time. So at the end of the day, short sellers help themselves and other short sellers by entering into a short trade.
Thanks for reading and we hope you learned something about short-selling!