What Is Short Selling?

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Short selling allows investors to profit from stocks or other securities when they go down in value. In order to do a short sale, an investor has to borrow the stock or security through their brokerage company from someone who owns it. The investor then sells the stock, retaining the cash proceeds. The short seller hopes that the price will fall over time, providing an opportunity to buy back the stock at a lower price than the original sale price. Any money left over after buying back the stock is profit to the short seller.

When short selling makes sense

At first glance, you might think that short selling would be just as common as owning stock. However, relatively few investors use the short selling strategy.

One reason for that is general market behavior. Most investors own stocks, funds, and other investments that they want to see risein value. Over time, the stock market has generally gone up, albeit with temporary periods of downward movement along the way. For long-term investors, owning stocks has been a much better bet than short selling the entire stock market.

Sometimes, though, you'll find an investment that you're convinced will drop in the short term. In those cases, short selling can be the easiest way to profit from the misfortunes that a company is experiencing. Even though short selling is more complicated than simply going out and buying a stock, it can allow you to make money when others are seeing their investment portfolios shrink.

The risks of short selling

Short selling can be profitable when you make the right call, but it carries greater risks than what ordinary stock investors experience. When you buy a stock, the most you can lose is what you pay for it. If the stock goes to zero, you'll suffer a complete loss, but you'll never lose more than that. By contrast, if the stock soars, there's no limit to the profits you can enjoy.

With a short sale, however, that dynamic is reversed. There's a ceiling on your potential profit, but there's no theoretical limit to the losses you can suffer. For instance, say you sell 100 shares of stock short at a price of $10 per share. Your proceeds from the sale will be $1,000. If the stock goes to zero, you'll get to keep the full $1,000. However, if the stock soars to $100 per share, you'll have to spend $10,000 to buy the 100 shares back. That will give you a net loss of $9,000 -- nine times as much as the initial proceeds from the short sale.

Still, even though short selling is risky, it can be a useful way to take calculated positions against a particular company. Managing your risk is important, but when used in moderation, short selling can diversify your investment exposure and give you an opportunity to capture better returns than someone who only owns stocks and other investments.

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