How does somebody make money short selling?

By Investopedia Staff AAA
A:

Short selling is a fairly simple concept: you borrow a stock, sell the stock and then buy the stock back to return it to the lender.

Short sellers make money by betting that the stock they sell will drop in price. If the stock drops, the short seller buys it back at a lower price and returns it to the lender.

For example, if an investor thinks Ben's Brewing Business (BBB) is overvalued at $25 and is going to drop in price, he or she may borrow the stock and sell it for $25. If the stock goes down to $20, the investor, after buying it back and returning it, would make $5 per share. However, if the stock goes up to $30, the investor would lose $5 per share.

If you can't see the amplified risk right now, let's make it obvious: when you buy a stock (or go long) you can lose only the money that you've invested. So, if you bought one BBB share at $25, the maximum you could lose is $25 because the stock cannot drop to less than $0. However, when you short sell, you can theoretically lose an infinite amount of money, because a stock's price can keep rising forever. So, for example, if you had a short position in BBB (or short sold it) and BBB ended up rising past $60 before you exited your position, you would lose $35 per share ($60-$25) - even more than the stock's original price.

While short selling does present investors with an opportunity to make profits in a declining or neutral market, it should only be attempted by sophisticated investors and advanced traders.

(For further reading, see our tutorial on Short Selling.)

RELATED FAQS

  1. What is a volatility smile?

    Discover what options traders mean when they refer to a "volatility smile," and learn why a volatility smile's existence ...
  2. Under what circumstances is short selling advisable?

    Find out when short selling a stock is profitable and what an investor should keep in mind before deciding to pursue a short ...
  3. Why is short selling illegal in some countries but legal in the U.S.?

    Discover why many countries around the world banned the practice of short selling financial stocks and why the United States ...
  4. Is short selling ethical?

    Understand the concept and practice of short selling, and examine the ethical questions that some investors raise in regard ...
RELATED TERMS
  1. David Einhorn

    Known for his short selling strategy, activist investor David ...
  2. Multibank Holding Company

    A company that owns or controls two or more banks. Mutlibank ...
  3. Short Put

    A type of strategy regarding a put option, which is a contract ...
  4. Wingspread

    To maximize potential returns for certain levels of risk (while ...
  5. Short Call

    A type of strategy regarding a call option, which is a contract ...
  6. Volatility Smile

    A u-shaped pattern that develops when an option’s implied volatility ...

You May Also Like

Related Articles
  1. Options & Futures

    Options -- Accessing Stakes In Apple ...

  2. Trading Strategies

    Risk Management Techniques For Shorting ...

  3. Options & Futures

    These Are The Top Brokerage Firms For ...

  4. Options & Futures

    Apple As An Example Of How a Protective ...

  5. Options & Futures

    Apple As An Example Of How to Use a ...

Trading Center