What is Short Selling, How it Works, and the Risks

By , on Feb 11, 2012

Short selling is the sale of shares in a stock that you do not own in hope that the price goes down even further, then you can buy back the shares at lower price and make a nice little profit. When you sell short, you borrow shares from your broker, sell the shares, and deposit the proceeds to your account. Later on you can buy back the shares and close your short position (e.g., short covering) and return the shares to your broker.

  • If the price drops, you can buy back the shares at a lower price and keep the difference as profit.
  • If the price rises, you have to spend extra money to buy back the same number of shares and you lose money.

Since you do not own the shares, you are responsible for paying the lender any dividend during the course of the loan. If the stock splits, you’ll have to buy back twice the number of shares at post-split price (which is usually about half).

Why Do Investors Short Sell?

In general, investors make money when the stock prices move up. Short selling allows investors to make money when the stock prices go down. Investors that short sell in hope of downward price movement is said to be speculating. For example, the sales of financial stocks during the Financial Crisis of 2008 before the ban were done in anticipation that these financial stocks will continue to lose value due to the crisis. People rushed out to short sell financial stocks so that they can later buy back shares at a much lower price and pocket the difference.

Short Selling as a Hedging Tool

A second reason for short selling is called hedging. Occasionally, an investor may want to maintain his long stock positions, but does not want to lose money due to short-term price drop. In this case, he could short sell the same number of shares as his long position, and the stock will not be affected by any price movement while it is hedged. Essentially, the amount of money he spent on commission is his insurance policy against price movement.

Short Selling Risks

Since stock price tends to move up over a long period of time, short selling is considered riskier than normal investing. In fact, you could theoretically lose an infinite amount of money to short selling! For example, imagine how much money you would owe if you sold Microsoft short on Black Monday, 1987 and did not cover your position — theoretically speaking.

Another risk is known as short squeeze — a situation where a sudden price increase causes many short sellers to cover their position and further drive up the price (and you lose more money).

That is short selling in a nutshell. It is something that I have avoided as an investor because I don’t like the speculative nature and higher risk. Have you tried it and what have you learned from the experience?

Author

Andy Tenton Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the owner of Money Destiny and the publisher of WorkSaveLive.com.

{One Comment}

  1. Alan:

    Nice article. I did have one question regarding your Microsoft example during Black Monday, did their price go up or drop like everyone else? The reason I am asking is that if their price dropped, wouldn’t that be a good thing since you short the stock? Maybe I am reading it wrong or Microsoft increased that day.

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