When you short sell a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition, you borrow shares from your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition firm because you think that the price of the stock is going to fall. You sell the borrowed shares at the current price and if the price drops, you make money by buying the shares back at the lower price and then returning them to your investment firm. But if the price rises, you’ll lose money if you have to buy back the shares at the higher price.
The theory behind short selling
- Borrow shares – usually from your investment firm
- Sell them – at the current price
- Buy them back – at a lower price and make a profit
- Return the borrowed shares – to your investment firm (called covering)
If the share price goes up instead of down
You’ll lose money if you have to buy back the shares at the higher price, and then return them to the investment firm. Theoretically, there is no limit to how high the price of a stock could go – losses could be catastrophic. This is the greatest risk of short selling.
3 things to know about short selling
- Short account – You must have a short account to engage in short selling. A short account is a type of margin account.
- Delivery of shares – Your investment firm can require you deliver the shares to them at any time. You’ll have to buy back the shares at the current market price and return them to the firm. If the share price has gone up, you’ll lose money.
- Dividends – Because you don’t actually own the shares, you have to pay your investment firm any dividends that are declared during the course of the loanLoan An agreement to borrow money for a set period of time. You agree to pay back the full amount, plus interest, by a set date.+ read full definition.
If you short sell a stock, you’re speculating that the price is going to fall. But if the price goes up, you’ll lose money.