An investor can short sell almost any asset or financial instrument. To make explaining short selling easier we’re going to talk about how short selling works when it comes to stocks.
Before we go into short selling let’s talk about long positions. When someone is said to be “going long” they purchase a stock and hold onto it in hopes it will increase in value. In short selling it’s almost the exact opposite, and the investor is hoping the stock’s value declines.
In short selling an investor will borrow a stock from a broker and immediately sell it at market value. Sometime in the future they will try to cover their short position by buying back the stock at a lower price and delivering the loaned stock back to the broker.
It may be easier to understand by using an example. An investor borrows and sells 100 shares in stock at $20 per share for a total of $2,000. Later the value of stock drops considerably to $10 per share. At this time the investor buys 100 shares at the current market value for $1,000. Their gross profit here is $1,000, less broker commissions, margin and the cost to borrow the stock. Even after those are paid the investor has made a profit by short selling the stock.
However, what if the stock does not drop in value? Using the same example of 100 shares sold at $20 per share, what if the price rises and hits $40? At this point the investor, to try and avoid further losses buys 100 shares at $40 per share, which costs $4,000. In this instance they’ve lost $2,000. In some instances, the broker may request additional margin for short sales. If a short seller cannot provide the margin, the broker may buy the stock and seek any differences from the short seller.
There is a risk of unlimited losses associated with Short selling where the stock continues to rise and losses increase along with the rise in the stock price.