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 options strategies are best suited for investing in the aerospace sector?

    Learn how investors profit from volatility in the aerospace sector by employing options strategies, which include the long ...
  2. What options strategies are best suited for investing in the Internet sector?

    Learn how two popular options strategies, the long straddle and the long strangle, enable investors to make money on the ...
  3. How many attempts at the Series 7 exam are permitted?

    The National Association of Securities Dealers (NASD) has not placed any limits on the number of times you can attempt to ...
  4. Where can I buy covered call ETFs (exchange-traded funds)?

    Learn where to trade covered call option strategies, and how covered calls work including the type of risk associated with ...
RELATED TERMS
  1. Catastrophe Equity Put (CatEPut)

    Catastrophe equity puts are used to ensure that insurance companies ...
  2. Open Trade Equity (OTE)

    Open trade equity (OTE) is the equity in an open futures contract.
  3. David Einhorn

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

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

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

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

You May Also Like

Related Articles
  1. Trading Strategies

    Bucking The Trend With Pattern Failure ...

  2. Options & Futures

    Why Is Best Buy Stock So Volatile?

  3. Trading Strategies

    A Guide Of Option Trading Strategies ...

  4. Technical Indicators

    Use Volume And Emotion To Tackle Topping ...

  5. Active Trading Fundamentals

    Where And How To Trade Energy Stocks

Trading Center