In short selling, an investor borrows stock that they think will decline by the upcoming expiration date.
The investor then sells the shares that they borrowed to buyers willing to pay the current price.
The investor waits for the price of the borrowed shares to drop so that they can buy them back at a lower price, before returning them to the broker.
But if the shares don't drop and instead rise, the investor will have to buy them back at a higher price than what they paid, and thus lose money.
What is Short Selling?
A buy or sell transaction in reverse. An investor wanting to sell shares borrows them from a broker, who sells the shares from the inventory on behalf of the person seeking to sell short.
Once the shares are sold, the money from the sale is credited to the account of the short seller. In effect, the broker has loaned the shares to the short seller. Eventually, the short sale must be closed by the seller buying an equal amount of shares with which to pay back the loan from his or her broker. This action is known as covering. The shares the seller buys back are returned to the broker, thus closing the transaction.
The ideal situation for the seller occurs if the stock price drops and he or she can buy back the shares at a lower price than the short sell price.
Example of Short Selling
To illustrate the short selling process, consider the following example.
A seller goes through a broker and requests to sell 10 shares of a stock currently priced at $10 a share. The broker agrees and the seller is credited with the $100 in proceeds from the sale. Assume that over the short term the stock drops to $5 a share. The seller uses $50 of that $100 to buy 10 shares to repay the broker and close the transaction.
The seller's remaining profit is $50. Of course, if the shares rise in price, forcing the short seller to purchase them at a higher price than the short sell price, the seller sustains a loss.
Interested in a real story of how people benefited from 'shorting'? Check out the movie below.
This tells you how a fund manager anticipated the collapse of the housing market ahead of the 2007-2008 financial crisis, and later became one of the few who made huge profits by shorting.
But, Shorting is also very risky!
Short selling involves a number of risks, including the following:
Skewed risk-reward payoff
Unlike a long position in a security, where the loss is limited to the amount invested in the security and the potential profit is boundless (in theory at least), a short sale carries the theoretical risk of infinite loss, while the maximum gain—which would occur if the stock drops to zero—is limited.
Going against the grain
As noted earlier, short selling goes against the entrenched upward trend of the markets. Most investors and other market participants are long-only, creating natural momentum in one direction.
Timing is everything
The timing of the short sale is critical, since initiating a short sale at the wrong time can be a recipe for disaster. Because short sales are conducted on margin, if the price goes up instead of down, you can quickly see losses as brokers require the sales to be repurchased at ever-higher prices, creating a so-called short squeeze.
So, why do people use short selling?
Traders may use it as speculation, a risky trading strategy in which there is the potential for both great gains and great losses.
Some investors may use it as a hedge against the possibility of losing money on a bet on the same security or a related one. Hedging involves placing an offsetting risk to counter the potential downside effect of a bet on a particular security.
Source: Investopedia, Moomoo