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.)

  1. Please explain what a short seller is on the hook for when he or she shorts a stock ...

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  2. Can a stock lose all its value? How would this affect a long or short position?

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  3. I want to try short selling, but how can I sell something that I don't own?

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  4. How does short selling help the market and investors?

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  5. Why do you need a margin account to short sell stocks?

    The reason that margin accounts and only margin accounts can be used to short sell stocks has to do with Regulation T, a ... Read Answer >>
  6. What happens when the lender of the borrowed shares in a short sale transaction wants ...

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