Short-selling stocks is an investment technique where an investors plans to profit off the declining price of a security. A short-seller borrows shares of stock they do not own and sells them out on the open market. When the value of the stocks fall, the short-seller can then buy back the borrowed shares at a lower price (or close out their short positions) for a profit. During times of economic uncertainty or bear markets, shorting stocks becomes a popular investment strategy.
How Short Sellers Profit
Short sellers are traders and investors that believe the price of a stock or other security will decline. For example, if an investor believes shares of XYZ will fall from their current price of $10 per share, they will short the stock by borrowing shares from a broker to sell the stock. If shares of XYZ fall to $8 per share at a later time, the short seller can close out their position by buying back the cheaper shares. The short sellers profit on the short sale will then end up being $2 per share before fees. When shorting stocks, the profit potential is limited to a 100 percent of the current share prices.
Risks of Short Selling
While investors and traders can profit by shorting stocks and other assets, there is significant risk to a short strategy. Using the above example, if share prices of XYZ had increased to $12 per share as opposed to dropping to $8 per share, the short sellers would actually lose $2 per share instead of netting a profit. Given that there is no limit to how high share prices of a stock can go, theoretically, the potential for losses in a short position is also unlimited. This is why it is recommended that investors and traders shorting stocks should use stop orders to limit downside risk.