You don’t always need to own a security to sell it and make a profit.
You don't always need to own a security to sell it and make a profit. Welcome to the extreme sport of short selling, where risk is the name of the game.
Short selling consists in selling a security that you do not own, with the hope of seeing its value decrease in order to pocket the difference. This transaction is carried out through a broker who "lends" the security in question.
For example, if a stock trades at $6 and you believe that its price will drop, you can short sell 1,000 shares for $6,000. If two weeks later, the stock trades at $5, you can buy back the same number of shares for $5,000, and resell them to the broker who had lent them to you. Realized gain? $1,000 in two weeks. Not bad!
However, in the investment world, the size of the gain and the time within which it is realized are proportional to the risk involved. From that perspective, short selling is not made for everyone.
Considerable risks ahead
When things don't go as planned, short selling can quickly turn sour. In fact, if the value of the stock increases, losses are virtually infinite, as no one can predict how high it will go.
Of course, you can bet on the fact that it is likely to start decreasing again at some point but sooner or later, you may have to face reality, close your short position, and return the borrowed shares to the broker. The broker in fact has the right to request the closing of the short position at any time because he only owns a limited number of these shares and could need them if several of his clients are looking to sell them.
Minimum margin requirement
Another risk factor: short selling is carried out through a margin account. It is a loan and therefore bears an interest rate that must be reimbursed, even if you do not realize a gain on the transaction. To limit this risk, a minimum margin must be kept on deposit in the account before the transaction can be authorized. The percentage of this margin varies depending on the security's market value, and is determined by the Investment Industry Regulatory Organization of Canada (IIROC).
Finally, since you, as the short seller, do not own the shares, you cannot cash in dividends that may be paid out to shareholders; you must return them to the broker.
In summary, short selling can be an attractive strategy to quickly pocket additional gains, as long as you are ready to take on the risks associated with this transaction. For that reason, it is better suited to seasoned investors who have great tolerance to risk and the financial means to cover the required margin.