A:

One way to make money on stocks whose price is falling is called short selling (or going short). 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 place a bet that the stock they sell will drop in price. If the stock does indeed drop after selling, the short seller buys it back at a lower price and returns it to the lender.

For example, if an investor thinks that Tesla (TSLA) stock is overvalued at $315 per share, and is going to drop in price, she may borrow 10 shares of TSLA from her broker and sell it for the current market price of $315. If the stock goes down to $300, she 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 TSLA price rises to $355, the investor could net $315 - $355 = - $40 loss per share.

What are the risks?

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 TSLA share at $315, the maximum you 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 you short sell, you can theoretically lose an infinite amount of money, because a stock's price can keep rising forever. Like in the example above, if you had a short position in TSLA (or short sold it) and it ended up rising to $355 before you exited your position, you would lose $40 per share.

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.

See our tutorial on Short Selling and read more about The Basics of Short Selling.

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