Short selling is a strategy used by stock market traders to make a profit on shares they expect will lose value.
Here’s how it works. A trader “borrows” shares from an investor and then sells them on the open market. Then he/she waits for the price to drop and buys the same number of shares back at the lower price. The trader then returns the borrowed shares to the original investor. The difference between the sale price and the buy-back price is the trader’s profit.
This is an example of using short-selling to generate profit as a speculator. At other times, short selling is used by investors to minimize the impact of a significant drop in the price of shares they already own—this is a hedging strategy.
Short selling can be risky and should be used only by experienced traders.
More about short selling
The following example shows how short selling works for a trader who is speculating to make a profit.
A trader believes that ABC Company’s shares—which are currently trading at $25 each—will fall in price. He or she borrows 50 shares and sells them. By selling these borrowed shares, the trader is now “short” 50 shares in ABC Company, as he or she will have to replace the shares in future.
A month later, the ABC Company’s stock price falls from $25 to $18. With this news, the trader decides to close the short position—i.e., buy back 50 shares at $18 to replace the ones he or she borrowed. By doing so, the trader makes a profit of $350 on the short sale (50 shares x $25 minus 50 shares x $18).
However, the trader could just as easily have lost money. If ABC Company’s share price had risen from $25, the original shareholder could demand that the borrowed shares be returned and the trader would have to buy replacement shares at the new price—meaning the trader will have acquired the new ones at a loss.