Selling short, or short selling, is a strategy used in trading stocks. In the selling short process, you borrow the shares of the stock in question from your stock broker. You then turn around and sell the stock shares borrowed for a certain price that the market offers. Your hope is that the price of the stock will drop, so that you can buy back the stock shares for a lesser amount. This creates a profit for your transaction. The practice is buying low and selling high done in the reverse order.
If the price of the stock drops, then this process of short selling makes you money. The down side to it is that when the price of the stock instead rises, then you lose money. Detractors of selling short claim that you can subject yourself to an unlimited amount of risk, since stock prices could rise without stopping. This means that you could potentially lose more than the amount of money that you invest if a given stock that you sold short took off and ran away without you closing out the transaction. Profits are limited by the distance of the stock price to zero, since a share’s price can never decline below zero.
Such selling short trades are closed out by repurchasing the shares that you sold short earlier. When it is time to close out the transaction by buying back the shares, this is called covering. The other names for this process are buy to cover or simply cover.
There are risks involved in selling short stocks. The biggest risk is that the stock could go up indefinitely. For example, you might sell short ten shares of IBM’s stock at $100 per share. This means that you have put a thousand dollars into the trade. If the stock later declined to ninety, then you would realize a gain of one hundred dollars. If instead it rose to $130 before you covered it, then you would lose three hundred dollars. While the lowest that the IBM shares might decline is to zero, potentially making you as much as one thousand dollars in profits, they could also rise to three hundred dollars, losing you two thousand dollars.
Short sellers can also fall victim to a short squeeze. As the stock price that you have shorted rises, some investors who shorted it will choose to limit their losses by buying the stock back. Still other investors may have no choice but to buy back the shares in order to satisfy any margin calls on their declining valued position. All of this buying back to cover creates a bigger increase in the price of the stock. The final outcome is a large move up in the price of the stock that creates significant losses for those who continue to be short the stock.