One way to make money on stocks for which the price is falling is called short selling (or going short). Short selling is a fairly simple concept: an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender.
Short sellers are betting that the stock they sell will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender.
Short selling is risky. Going long on stock means that the investor can only lose their initial investment. If an investor shorts a stock, there is technically no limit to the amount that they could lose because the stock can continue to go up in value.
For example, if an investor thinks that Tesla (TSLA) stock is overvalued at $315 per share, and is going to drop in price, the investor may borrow 10 shares of TSLA from their broker and sells it for the current market price of $315. If the stock goes down to $300, the investor could buy the 10 shares back at this price, return the shares to her broker, and net a profit of $315 (selling price) - $300 (buying price) = $15 per share.
However, if the TSLA price rises to $355, the investor could net $315 - $355 = - $40 loss per share.
What Are the Risks?
Short selling comes involves amplified risk. When an investor buys a stock (or goes long), they stand to lose only the money that they have invested. Thus, if the investor bought one TSLA share at $315, the maximum they could lose is $315 because the stock cannot drop to less than $0. In other words, the minimum value that any stock can fall to is $0.
However, when an investor short sells, they can theoretically lose an infinite amount of money because a stock's price can keep rising forever. As in the example above, if an investor had a short position in TSLA (or short sold it), and the price rose to $355 before the investor exited, the investor would lose $40 per share.
- Short sellers are betting that a stock will drop in price.
- Short selling is riskier than going long on a stock.
- Speculators short sell to capitalize on a decline while hedgers go short to protect gains or minimize losses.
- Short selling is worthwhile if an investor is sure that a stock's value will drop in the short term.
Why Do Investors Go Short?
Short selling can be used for speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or the broad market. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio.
Note that institutional investors and savvy individuals frequently engage in short-selling strategies simultaneously for both speculation and hedging. Hedge funds are among the most active short-sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks.
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 due to its risk of infinite losses.
When Does Short Selling Make Sense?
Short selling is not a strategy used by many investors largely because the expectation is that stocks will rise in value. The stock market, in the long run, tends to go up although it certainly has its periods where stocks go down. Particularly for investors who are looking at the long horizon, buying stocks is less risky than short-selling the market. Short selling does make sense, however, if an investor is sure that a stock is likely to drop in the short term. For example, if a company is experiencing difficulties.