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

By Pinyo, on September 23, 2008

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?

Pinyo is the owner of Moolanomy Personal Finance and an entrepreneur with over 20 years of business experience. He is interested in business management, investing and wealth management. He has written for many online publications, including American Express Currency and U.S. News Money. You can follow him on Facebook and Twitter.

Add Your Question or Comment (5 Comments)

1. Dividend Growth Investor:

   September 23, 2008 at 10:14 am

   I have done short selling and I have lost a lot of money doing it. Nice overview by the way. I liked this part:

   “Since you don’t own the stock, 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.”

   However I think that you might want to add that you will have to buy back twice the number of shares, but that their prices will also be half of what they were prior to the split. Some novice investors might think that’s an overlooked market inefficiency
2. Pinyo:

   September 23, 2008 at 10:21 am

   @DGI — Thank you. I’ve added the clarification.
3. Mr. ToughMoneyLove:

   September 23, 2008 at 11:53 am

   Two additional short selling issues that are worth mentioning: (1) naked short selling (not borrowing or arranging to borrow the shares) has been illegal but poorly enforced by the SEC; and (2) the elimination of the “uptick” rule in 2007 made it easier for large institutions to sustain negative momentum in support of their short positions.

   I think you might see the return of the uptick rule and (I hope) more vigorous enforcement of the rule against naked short selling.
4. Dividend Growth Investor:

   September 23, 2008 at 5:24 pm

   TML, I actually agree with you that one of the reasons behind the severity of the current bear market declines lies in the fact that the uptick rule for selling short was discontinued.
5. Pinyo:

   September 24, 2008 at 9:30 am

   @TML — Thank you for the additional points. I agree that the elimination of uptick rule allows short selling to be exploited more readily.