Investors can make money on a decline in individual stocks, thanks to an investing technique called short selling. Short selling is not complex, but many investors have trouble understanding the concept.
In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.
The mechanics of a short sale are relatively complicated compared to a normal transaction. Investors face high risks for potentially high returns. It’s essential to understand how the whole process works before you get involved.
Buying and selling of stocks generally occurs through a stock broker who charges a fee for their services. You set up either a cash account, where you pay for your stock when you purchase or a margin account, where the broker lends you a portion of the funds and the security acts as collateral.
Short selling is the selling of a stock that the seller doesn’t own. The investor borrows shares, sells them and must eventually return the same shares. Profit or loss is made on the difference between the prices at which the shares are borrowed compared to when they are returned. An investor makes money only when a shorted security falls in value.
Short selling is done on margin, and so is subject to the rules of margin trading. The shorter must pay the lender any dividends or rights declared during the course of the loan.
The two main reasons for shorting are to speculate and to hedge. There are restrictions as to what stocks can be shorted and when a short can be carried out. Short selling is very risky, you can lose more money than you invest but are limited to 100% profit on the upside.
Critics of short selling see it as unethical and bad for the market but short selling contributes to the market by providing liquidity, efficiency and acting as a voice of reason in bull markets.