Short Selling Explained
An investment strategy that lets you profit from falling stock prices.
Key Takeaways
Long trades look to make money from the stock price increasing, while short trades look to make money from the stock price decreasing.
Long trades are often called being “bullish” on a stock, while short trades are often called being “bearish” on a stock.
Short Selling is when an investor borrows shares from the stock brokerage, immediately sells it, and then attempts to buy back the same shares at a lower price.
Often when listening to experience stock traders discuss buying and selling stocks, many will say they are “long” or “short” a stock. But in reality all this is just fancy terminology for whether the investor believes the stock price will increase or decrease.
Long trades look to make money from the stock price increasing, while short trades look to make money from the stock price decreasing.
Long trades are often called being “bullish” on a stock, while short trades are often called being “bearish” on a stock.
Long Trade
A long trade is simply just buy a stock and only requires you to have enough money to pay for the shares and broker commission. For instance, being long 100 shares of XYZ Company means you have bought 100 shares with the intent to make money on the stock as the stock price increases. Since XYZ Company's stock can't go any lower than $0. Your maximum potential loss is 100% of your money, but your potential profit is unlimited as the sky's the limit for a stock's price.
Short Trade
Short trades also known as “short selling” are trades that look to make money from the stock's price decreasing. Short selling is a little more complicated than being long a stock. Because of this, an account with special requirements and borrowing privileges, called a margin account is required to be able to short sell a stock.
This is because an investor technically borrows the shares from the stock brokerage, immediately sells it, and then attempts to buy back the same shares at a lower price. All this is with the intention on returning the borrowed shares and profiting the difference. This sounds complex, but it happens instantly behind the scenes when you choose to short sell a stock.
Short selling can be riskier than buying a stock and is not recommended for inexperienced investors. This is because since you make money when a stock price falls and lose money when the stock price rises.
Potential gains are capped at 100% as a stock can go no lower than $0. However, potential losses are technically unlimited, because a stock price has no upper limit.
To explain this concept we use the following example of XYZ Company:
If you short sold one share of XYZ Company at $100 a share and the stock price increased to $200 a share you have lost 100% of your investment.
But if the stock continues to rise to $300 a share before you can buy the borrowed shares back you now have lost 200%. Meaning, you have lost your original $100 investment and you owe your stockbroker an additional $100.
But if you're right on your prediction of XYZ company's stock price, and it decreases to $40 a share, you will profit $60 when you return the borrowed shares.
Ultimately, most investors should go long on companies they believe will rise in stock price in the future. History shows that this has been a great strategy, especially in the United States. Going short on stocks can also be profitable, but you should remember this process has a little more risk.