Short selling involves selling a security that one does not own, in an attempt to profit from a fall in the stock price.

Short-sellers borrow shares of the stock from their broker, then sell the stock, hoping to buy the stock back at a lower price and to pocket the difference in prices. We won’t get into the intricacies of short selling here, but rather the reasons why market participants would consider shorting a stock.

Speculation

Money managers, traders and institutions might look to short sell a stock to speculate on a potential price decline. This may be due to technical, fundamental or quantitative analysis that indicates the stock could fall. These short sellers will borrow shares to sell the stock in anticipation of a price decline based on their analysis.

Hedging

Portfolio managers, money managers and arbitrageurs often sell a stock short in an attempt to hedge against a price decline in another similar security, when the stock is not optionable. For example, let’s assume the overall outlook on the gold industry is mixed, and a money manager is long shares of the SPDR Gold Trust (GLD). He wants to hedge that position but GLD options are expensive and, perhaps, the manager doesn’t want to be subject to the time decay in options. The manager could short shares of another gold-related ETF — such as the VanEck Vectors Gold Miners ETF (GDX) to potentially hedge against a fall in gold prices.

Here’s a look at how GLD and GDX trade.

Source: TradingView

These two exchange-traded funds (ETFs), more or less, have the same price movements, and consequently, being long one and short the other could potentially hedge the long position.

Market makers may sell short to keep trading balanced

Market makers provide liquidity to the market. If there’s an absence of sellers, and a market maker has no position in a stock, they might step in and short the stock. For example, let’s assume there is a large order to buy a stock, which would cause an imbalance in trading, market makers might look to increase liquidity on the sell side by positing ask prices and add to the supply of the stock by shorting it.

The bottom line

There are a multitude of reasons why market participants might look to sell short, but keep in mind that it may be more than simply expecting the value of a security to decline. There are a lot of intricacies behind short selling; before you consider shorting a stock, define why you want to do it, then look into the rules behind short selling.

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  Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.

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