Short-selling allows investors to profit from stocks or other securities when they go down in value. In order to sell short, an investor has to borrow the stock or security through their brokerage company from someone who owns it. The investor then sells the stock, retaining the cash proceeds. The short-seller hopes that the price will fall over time, providing an opportunity to buy back the stock at a lower price than the original sale price.
Any money left over after buying back the stock is profit to the short-seller. At first glance, you might think that short-selling would be just as common as owning stock. However, relatively few investors use the short-selling strategy.
One reason for that is general market behavior. Most investors own stocks, funds, and other investments that they want to see rise in value. The stock market can fluctuate dramatically over short time periods, but over the long term it has a clear upward bias.
For long-term investors, owning stocks has been a much better bet than short-selling the entire stock market. Shorting, if used at all, is best suited as a short-term profit strategy. Sometimes, you'll find an investment that you're convinced will drop in the short term. In those cases, short-selling can be a way to profit from the misfortunes that a company is experiencing.
Even though short-selling is more complicated than simply going out and buying a stock, it can allow you to make money when others are seeing their investment portfolios shrink.
Short-selling can be profitable when you make the right call, but it carries greater risks than what ordinary stock investors experience. Specifically, when you short a stock, you have unlimited downside risk but limited profit potential. Table of Contents Expand.
Table of Contents. Why Sell Short? How Shorting Stock Works. What Are the Risks of Short Selling? Learn about our editorial policies. Reviewed by Charles Potters. Article Reviewed October 30, Charles is a nationally recognized capital markets specialist and educator with over 30 years of experience developing in-depth training programs for burgeoning financial professionals. Charles has taught at a number of institutions including Goldman Sachs, Morgan Stanley, Societe Generale, and many more.
Learn about our Financial Review Board. Key Takeaways Short stock trades occur because sellers believe a stock's price is headed downward. Shorting stock involves selling batches of stock to make a profit, then buying it back cheaply when the price goes down.
Stock prices can be volatile, and you cannot always repurchase shares at a lower price whenever you want. Shorting a stock is subject to its own set of rules that are different from regular stock investing. A long position may be owning shares of the same or a related stock outright. Article Sources. Part Of. Your Privacy Rights. To change or withdraw your consent choices for TheBalance. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.
The most obvious reason to short is to profit from an overpriced stock or market. Probably the most famous example of this was when George Soros "broke the Bank of England" in For reasons we'll discuss later, very few sophisticated money managers short as an active investing strategy unlike Soros. The majority of investors use shorts to hedge.
This means they are protecting other long positions with offsetting short positions. There are many restrictions on the size, price and types of stocks you are able to short sell. For example, you can't short sell penny stocks and most short sales need to be done in round lots.
This triggers a steeper price ascent in the stock as more and more short sellers buy back the stock to close out their short positions and cap their losses. In January , followers of a popular Reddit page called Wall Street Bets banded together to cause a massive short squeeze in stocks of struggling companies with very high short interest, such as video game retailer GameStop.
This caused the company's share prices to soar fold and sixfold in January alone. Short selling can generally only be undertaken in a margin account , a type of account by which brokerages lend funds to investors and traders for trading securities. Therefore, the short seller has to monitor the margin account closely to ensure that the account always has sufficient capital or margin to maintain the short position. If the stock that the trader has sold short suddenly spikes in price for example, if the company announces in its quarterly report that earnings have exceeded expectations , the trader will have to pump additional funds into the margin account right away, or else the brokerage may forcibly close out the short position and saddle the trader with the loss.
If an investor shorts a stock, there is technically no limit to the amount they could lose because the stock can continue to go up in value indefinitely. In some cases, investors could even end up owing their brokerage money.
Short selling can serve the purposes of speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or across the market as a whole. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio.
Notably, institutional investors and savvy individuals frequently engage in short-selling strategies for both speculation and hedging simultaneously.
Hedge funds are among the most active short-sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks. Though short selling does present investors with an opportunity to make profits in a declining or neutral market, only sophisticated investors and advanced traders should attempt it due to its risk of infinite losses.
Short selling is not a strategy many investors use, largely because the expectation is that stocks will rise in value over time. In the long run, the stock market tends to go up, although it is occasionally punctuated by bear markets in which stocks tumble significantly. For the typical investor with a long-term investment horizon, buying stocks is a less risky proposition than short selling.
Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties.
That said, only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it. Trading commissions are not the only expense involved when short selling.
There are other costs, such as:. Yes, you can lose much more than you have invested in a short sale; in theory, your losses can be infinite. This is the reverse of a conventional "long" strategy, by which the maximum gain on a stock you have purchased is theoretically infinite, but the most you can lose is the amount invested.
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