Tuesday, October 4, 2011
Explanation on short-selling.
Let's say you rent a movie from a video store for one month and it costs $5. But the movie is fully yours for the month and you can do whatever you want during the one month as long as you return the same movie at the end of the month. The video store doesn't care.
Let's say your friend wanted to buy the movie, at the moment, the movie costs $20. So you sell it to your friend for $20 and now you're $20 richer.
But the problem is you still have to return the same movie at the end of the month.
So you wait and wait and finally at the end of the month the price of the movie drops. It now costs $10. You pay $10 for the movie and return it back to the video store.
Let's see if you made a profit:
-$5 (movie rental)
+$20 (sold movie to friend)
-$10 (bought movie)
= $5 profit
So you made $5, but if the cost of the movie went up, you would have lost money. The only reason you made money is because you waited and luckily the price went down.
Short-selling is very risky because you have to make sure the price will go down and when. You could lose a lot of money if you bought a lot of movies and if the price went up you could lose a lot of money.