Short selling is a technique used by investors to try to profit from the falling price of a stock. As such, short selling is typically used when an investor believes a stock is overvalued or there is an upcoming event that will trigger a substantial decline in the stock price. An investor may also deploy this technique as a way to hedge overall portfolio risk or balance the risk of one investment relative to another.
Here's how short selling works. Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone who owns them with the promise that you will return them later. You immediately sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you "cover your short position" by buying back the shares, and your broker returns them to the lender. Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses for borrowing the stock.
However, if you're wrong, and the price of the shares increase, the potential losses are unlimited. The company's shares may go up and up, but at some point you have to replace the 100 shares you sold. In that case, your losses can mount without limit until you cover your short position. For this reason, short selling is a relatively risky technique.
Another reason short selling is riskier is that markets tend to go up over time, due to inflation and productivity gains, and thus an investor is essentially going against this trend. Due to these factors, short selling positions are typically not as long as buying stocks tend to appreciate in value and are generally used to generate short term trading profits.
Something else to be aware of is that because the stocks are being borrowed from the shareholders, investors pay interest on the loaned shares and are also required to cover any dividends being paid. Both of these factors erode potential gains.
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