Short selling is a strategy to use when you expect a security’s price will decline. The traditional way to profit from stock trading is to “buy low and sell high”, but you do it in reverse order when you wish to sell short. To sell short, you sell shares of a security that you do not own, which you borrow from a broker. After you short a position via a short-sale, you eventually need to buy-to-cover to close the position, which means you buy back the shares later and return those shares to the broker from whom you borrowed the shares. You can make a profit from short selling if you buy back the shares at a lower price.
When you trade stocks in the traditional way (“buy low and sell high”), the maximum amount that you can lose is your initial investment. However, when short-selling, your losses are theoretically unlimited, since the higher the stock price goes, the more you could lose. All short sale orders must be executed through a margin account. You will be charged interest only on the shares you borrow, and you can short the shares as long as you meet the minimum margin requirement for the security.
Example of Short Selling:
An investor believes that Stock A, which is trading at $100 per share, will decline when the company announces its annual earnings in one week. Therefore, the investor borrows 100 shares from a broker while short selling those shares to the market. So now the investor “shorts” 100 shares of Stock A which he did not own with hopes that the share price will decline.
A week later, Stock A’s price falls to $90 per share after the company announces annual earnings. The investor decides to close the short position, so he buys back 100 shares of Stock A from the open market at a price of $90 per share and returns those shares to the broker; this is a buy-to-cover order. Therefore, the investor makes a profit of $10 per share which is a total of $1,000 for the whole transaction not including commissions and interest.
However, if the stock price increases to $110 per share and the investor decides to close the short position, he will need to buy-to-cover the 100 shares from the open market at the current price of $110 per share. The loss for this short sale transaction will be $10 per share which amounts to a total loss of $1000 (excluding commissions and interest), since the shares were bought back at a higher price.