What It Is:
Short selling is a trading strategy that seeks to capitalize on an anticipated decline in the price of a security. Essentially, a short seller is trying to sell high and buy low.
How It Works/Example:
Short selling involves a three-step process.
1) Borrow shares of the security, typically from a broker.
2) Sell the shares immediately at the market price.
3) Repurchase the shares (hopefully at a lower price) and return them to whoever you borrowed them from. After all this, you will pocket the difference if the share price has fallen, but will have lost money if the price went up.
We'll illustrate the process with an example:
Mr. Johnson believes that the stock of ABC Corp. will fall in the future. He calls his broker and asks him to find 100 shares of ABC that he (Mr. Johnson) can borrow for a short sale. ABC's current price is $25 per share. Mr. Johnson receives a cash inflow of $2,500 after he sells the shares he has borrowed.
Two weeks later, the price has indeed dropped, and shares of ABC now trade for $20 each. Mr. Johnson buys back the shares (known as covering his short position) for $20 each. He spends $2,000 to repurchase the shares and returns the shares to the person he borrowed them from.
Mr. Johnson's profit on the trade is $500 ($2,500 received from the sale of the stock minus $2,000 paid to repurchase the stock).
Using this same calculation, we see that if the shares had risen to $27 during his holding period, then he would have lost $200 ($2,500 received from the sale of the stock minus $2,700 paid to repurchase the stock).
Why It Matters:
Short selling is a way for investors to benefit from a decline in a stock's price. The market always needs people on both the long end (owners/buyers) and the short end (renters/sellers) for it to work properly.
Short selling is controversial because when a large number of investors decide to short a particular stock, their collective actions can have a dramatic impact on the company's share price. Many companies will blame short sellers for sharp declines in their stock. Bans on short selling have been enacted on several occasions. During the most recent credit crisis, investors were banned from selling short certain banks and financial institutions.
Short selling is risky for a number of reasons. First, an investor is exposed to theoretically unlimited losses if the underlying stock rises instead of falls.
Second, a sharp rise in a particular stock can trigger a large number of short sellers to cover their positions all at once. Short covering can push share prices even higher, causing even more short sellers to cover their positions, and so on. In this case, the stock is caught in a "short squeeze." Volatile stocks with large short interest are particularly susceptible to this phenomenon, and prospective short sellers should be wary of it.
An investor can quickly determine the percentage of a company's outstanding shares that are currently being sold short by checking the stock's "short interest." For example, a 10% short interest means that one of every ten outstanding shares is held short.