The concept of short selling is actually quite simple. The short seller borrows a stock, and proceeds to sell it immediately, receiving the proceeds up front. The short seller has the intention of buying the stock back at a later date for a lower price to return to the lender.
A short sell may occur when an investor, for one reason or another, believes that a particular company is overpriced. The investors places their bet and if they are correct, they will buy it back at a lower price and earning a profit.
Another reason for short selling is that it allows an investor to hedge their risks. An investor may want to hedge away the risk an existing position, or remove certain risks by entering into pair trade based on the relationship of a combination stocks.
As an example, I might believe that Delta Airlines ($DAL) is overvalued because of their business model. I want to short sell it, but at the same time and worried about the exposure to the overall airlines industry as a whole. In this situation, I might look at a using competitor company in the same industry America Airlines ($AAL). I would buy $AAL and short sell $DAL. This pair trade eliminates the risks of the airline industry (with one long and one short position), but still maintains my belief that $DAL is overvalued.
Let's use the example of Apple ($AAPL) which is currently trading around $135 (2021) at this time:
One of the major risks of short selling is the potential for unlimited loss. When buying or taking a long position, the most you can lose is the total value of your investment, with the price floored at $0. This luxury does not exist for short positions though.
There is no ceiling for your losses, as theroetically there is no limit to how much the stock price can go up. If the price increases by 10 times, you will need to owe back 10 times your initial investment.
This chart compares the profits at different price points for an investor who longs (buys) or shorts (sells) 100 shares of $AAPL at the of $135.
Another major risk of short selling is that markets tend to move up in the long run. Societial growth and advancements and the effects of inflation are two important forces that have continuously been push prices up. Holding short positions over the long term will on average result in losses.
Find out how short selling plays a vital role in our financial markets here!
