Short selling is a strategy used to profit from stocks that are overvalued. As a short seller, you would borrow — remember, borrow, and not buy — the stock of a company that you think is overvalued and will fall in the near future. You then sell the borrowed stock in the market and wait for the price of the stock to fall to a level, which you think is the fair value of the stock. If the price falls to the level you expected, you buy back the stock from the market and return the borrowed shares to the broker. The difference between the selling price and the price at which you buy back the stock is your profit, less the fee charged by your broker to lend you the stock. So, you have profited from a stock without actually owning it.
As an example, you think that a certain company’s stock, which is currently trading at $20, is overvalued. You expect the price to drop in the next 3 months. The next thing you do is, call your broker and borrow 100 shares of that company and sell it in the market. The proceeds of the sale, $2,000, are credited to your trading account with your broker. Now, you wait for the price to drop to a level where you can make the maximum profit.
For example, the price of the company’s stock falls to $15 after two months. You think that the price will not fall below this level, you buy the stock back, which is also known as covering your position. You pay $1,500 in the market to buy back 100 shares of the company and return it to your broker. There it is! You have made a profit of $500, minus the fee charged by the broker to lend you the stock, without actually owning the stock.
You can borrow the stock for as long as you want, but this is not advisable for two reasons; you will have to pay a higher cost for borrowing, and since you do not own the stock, the broker may ask for it back any time, which will force you to cover your position sooner than you wanted. So, unless you are sure that price will fall to a level where you can profit in a short period, do not go short. Additionally, you are also not entitled to receive any dividend payments made in the period you short the stock, since you are not the owner of the stock.
The major risk you face as a short seller is if the price of the stock does not fall to the level where you can profit from it for a long time, or if the price increases. Take the previous example where you expect the price to drop in 3 months. However, the price level increases to $25 after 3 months. Now, if your broker asks you to return the borrowed stock, you will make a loss of $500.
Remember, the profits from short selling are limited, as the price of a stock cannot fall below zero. However, you can make unlimited losses on your position because there is no limit to which the price of a stock can rise. So, you need to be completely convinced that the stock is overvalued, and that the price will fall within a short period of time.