The concept of short selling is actually quite simple. This is when an individual borrows a stock and proceeds to sell it immediately with the intention of buying it back at a later date.
When an investor believes that a particular stock is overpriced, a short sale allows the investor to place a bet that the stock price will decrease. If the price does indeed decreases, it will cost less for the investor to buy it back and resulting in them earning a profit.
Short selling can also be used as a tool for hedging risk or making a hedged bet on the relative prices between two stocks. For example, let's say I believe that Delta Airlines ($DAL) is overpriced compared to American Airlines ($AAL), but I don't want to be exposed to the risks of the airline industry as a whole. I would buy AAL and short sell DAL, betting that the gap in price between the two will close.
Let's use the example of Apple ($AAPL) which is currently trading around $135 at the time of writing:
One of the major risks of short selling is the risk of unlimited loss. When you buy a share of a company, the most you can lose is the total value of your investment as the price is floored at $0. But this is not the case when you are taking a short position.
When you short sell a stock, there is no limit to your losses because there is no limit to how much the price can increase. 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 to point out is that the markets have historically moved up over the long run as society progresses and we experience inflation. Holding a short position over the long run on the overall market will on average result in a net loss.
Find out how short selling plays a vital role in our financial markets here!
