How Short Selling Stocks Works

• Short sellers bet that a stock’s price will fall.
• Short selling is riskier than buying a stock because, in theory, there is no limit to how much you can lose.
• Speculators short sell to profit from a decline, while hedgers sell to protect gains or reduce losses.
• When it works, short selling can earn an investor a solid return over the short term, since stocks tend to lose value faster than they gain it.

Example of short selling:

For example, if an investor thinks Tesla (TSLA) stock is overpriced at $625 per share and expects the price to fall, the investor might borrow 10 shares of TSLA from their broker, who then sells them into the current market at $625. If the stock drops to $500, the investor can buy the 10 shares back at that price, return them to the broker, and net a profit of $1,250. However, if TSLA rises to $700, the investor loses $750.

What are the risks of short selling?

Short selling carries significant risk. When an investor buys a stock, they can only lose the money they invested. So if an investor buys TSLA at $625, the most they can lose is $625, because the stock cannot fall below $0. In other words, the lowest value any stock can fall to is $0.

However, when an investor sells short, they can in theory lose an unlimited amount of money, because a stock’s price can keep rising indefinitely. As in the example above, if the investor holds a short position in TSLA and the price climbs to $2,000 before the investor exits, they would lose $1,325 per share.

Why do investors turn to short selling?

Short selling can be used for speculation or hedging. Speculators use short selling to profit from a potential decline in a particular security or across the market as a whole. Hedgers use the strategy to protect gains or soften losses in a security or a portfolio.

Notably, sophisticated institutional and individual investors often run short-selling strategies for both speculation and hedging at the same time. Hedge funds are among the most active short sellers and frequently use short positions in specific stocks or sectors to hedge their long positions in other stocks.

While short selling gives investors a chance to make a profit in a falling or flat market, only experienced investors and advanced traders should attempt it, because of the risk of unlimited losses.

When does short selling make sense?

Short selling is not a strategy many investors use, because the general expectation is that stocks will rise in value. Over the long term the stock market tends to move higher, even though it certainly has periods when stocks fall.

Finally, for investors with a particularly long-term view, buying stocks is less risky than shorting the market. That said, short selling makes sense if an investor is confident a stock is likely to fall in the short term. For example, if a company is struggling and could miss a debt payment.

Short selling also means selling shares the seller does not own. More specifically, short selling is the sale of a security the seller does not own but has promised to deliver. The simplest way to think about it: when you short a stock, your broker lends it to you.

The shares come from the brokerage’s own inventory, from another of the firm’s clients, or from another brokerage. The shares are sold and the proceeds are credited to your account. Sooner or later you must close the sale by repurchasing the same number of shares, which is called covering, and return them to your broker. If the price has fallen, you can buy the stock back at a lower price and profit from the difference; the opposite is true if the price rises.

Frequently asked questions

Is short selling halal or haram?

Islamic scholars have, by consensus, permitted short selling, treating it in principle as one of the transactions that are not prohibited under Islamic law.

What is an overdraft (margin) account?

It is an arrangement that lets a client take a position in a financial asset such as a stock for an amount greater than their own deposit, based on a loan taken from the trading broker.

What are the risks of short selling?

The biggest obvious risk in short selling is the seller’s inability to absorb the loss if the price reverses sharply against them.

When is short selling applied?

Short selling happens when you sell a good or asset you do not own; the broker borrows the asset, and you later buy it back once it reaches the price you expected.