Short selling a stock can seem confusing but it is actually a simple concept. However, it is important to understand the potential risks involved before you consider shorting a stock.
In order to short sell a stock, you must have an account with a broker. You borrow a stock from that broker and sell it. Then at a later time, you buy the stock and give it back to your broker. You can make a profit if the value of the stock goes down between when you sell it and when you buy it. When you buy the stock for a short sale, it is known as covering.
Short Selling Example
Here is an example to better understand short selling. You think that a stock is going to decrease in value so you borrow 100 shares from your broker and sell it at $15.00 a share for at total of $1500.00. The next day the shares decrease in value and you buy 100 shares at $14.00 a share for a total of $1400.00 and give the shares back to your broker. Your profit for this trade is $100.00.
Risks of Short Selling
There are significant risks in short selling stocks that are different from standard buying and selling. In short selling, theoretically your losses can be infinite. You lose money in a short sale when the stock goes up instead of down. So, if a stock more than doubles in price, you can lose more than the initial dollar value of your investment. Another large risk is that stocks in general tend to rise in value over time even if they only keep pace with inflation. Finally, since you borrowed the stock initially, your broker can force you to replace it at any time. Although this rarely happens, it is a possibility.
Ethics of Short Selling
Short sellers are sometimes vilified as being against the economy and taking advantage of people’s misfortune. However, short sellers do add significant liquidity to the market and increase the efficiency by making it easier to match buyers and sellers.
“Short Sale Guideance.” Idaho Department of Finance. N.p., n.d. Web. 10 Mar. 2011. <finance.idaho.gov/Education/Documents/Combined%20DOF-IREC%20Short%20Sale%20Guidance.pdf>.
“Short Sales.” U.S. Securities and Exchange Commission (Home Page). N.p., n.d. Web. 11 Mar. 2011. http://www.sec.gov/answers/shortsale.htm.