What Is Short Selling?
Short selling, or taking a short position on a stock, is a risky way to profit from a stock that is losing value. By taking a short position, you are betting that the stock will lose value. When you buy a stock and expect the price to go up, that is called going long.
- Short selling is a risky way to profit from a declining stock; it is the opposite of going long, which is a way to profit from a rising stock.
- An investor takes a short position by borrowing shares, selling them on the market at a certain value, and then buying the shares back again at a lower price.
- The investor nets the difference between the price at which they originally sold the borrowed shares and the price that they must buy the shares back to return them to the lender.
- If an investor short sells a stock that goes bankrupt, this is the ideal situation because the investor owes nothing to the person from whom they borrowed the shares.
How Short Selling Works
When you short sell a stock, you borrow the shares, sell them on the market, and then collect the proceeds as cash. For example, let's say you want to short sell one share of ABC Bank because you think the stock value will fall. You borrow one share of ABC bank for $100 and sell it for $100, which is credited to your account. The stock then drops to a value of $70. You then buy a share at the value of $70 and return it to the person from whom you borrowed the share netting $30 into your account.
At any time, if you want to get out of the position, you must buy back the same number of shares to repay the person (or brokerage) from whom you borrowed the shares. Those investors who go short provide liquidity to markets and prevent stocks from being bid up to ridiculously high levels through hype and over-optimism.
Short selling follows the buy low, sell high principle, but with a reversal of the buy and sell transactions.
Short selling is risky because, in theory, there is no limit to the amount that you will lose.
Holding a Short Position on a Delisted, Bankrupt Company
Quite simply, if you have an open short position in a company that gets delisted and declares bankruptcy, then you don't have to pay back anyone because the shares are worthless.
Companies sometimes declare bankruptcy with little warning while other times there is a slow fade to the end. If you didn't close out your position before the shares stopped trading and became completely worthless, you may have to wait until the company is liquidated before paying off investors.
However, the short seller owes nothing—zero. Obviously, this is the best possible scenario for a short seller. Eventually, your broker will declare a total loss on the loaned stock, and your debt will be canceled with your collateral being returned.
Going short, which represents an attempt to profit from a falling stock, is the inverse of going long, which is an attempt to profit from a rising stock.
Why Short Selling Is So Risky
Short selling is not for the novice investor because, in theory, there is no limit to the amount that you can lose. If you short sell a share worth $100, and the share increases in value, you will have to buy back the share at whatever value the share holds at that time.
On the other hand, if you take a long position and buy a stock expecting that it will go up in value, and then the value drops, the most that you will lose is the initial amount that you paid for the stock.