You may have heard the investing maxim “buy low, sell high.” Short selling aims to do just that, except in reverse order.
Short selling is when you borrow stock in order to sell it, anticipating that you can buy the stock back at a lower price later, and then return the stock to its owner. This often seems like a strange concept at first, because it seems odd to sell something that you do not own. However, short selling is a mainstream and important practice in the securities markets.
Without short-selling, the price of a security may become too high because the market would be somewhat one-sided. No one outside of current owners would be able to sell the stock in order to bring it down to its fair value. It the current owners are not willing to sell at a lower price, then they may simply hold on to the stock and it will remain at a higher than normal price, with very low trading volume. Few people will want to buy in at the higher price, but no one except current owners can sell at a lower price.
Short sellers can bring this situation quickly into check by borrowing the stock and selling it. In this way, the views of those that believe the stock is overvalued are brought to bear on the stock, until there are enough buyers to support the price. This keeps the price close to fair value, where lots of people want to buy and sell. This is good for everyone, since it creates a very liquid market where buyers and sellers can easily exchange shares and cash as they wish.
Short selling is more risky that buying a stock, so it often requires that you fill out special forms with your brokerage in order for them to allow you access to this ability. The reason short selling is so risky is that unlike when you buy a stock, when you sell it short, your possibility for losses is unlimited. When you buy a stock, the worst that can happen is that the stock goes to zero, the company goes bankrupt, and you lose your entire investment. In short selling, you can actually lose far more than your initial investment.
Consider the case if you bet against a high-flying stock. Perhaps you think this stock is overvalued, so you short-sell it to profit from the decline. But instead of declining, over the next few months, the stock continues to appreciate. In order to exit your position, you have to buy back the stock at whatever the current price is. So if you sold short the stock at $30 a share, then if you have to buy it back at $60 per share, you will have lost $30 per share, your entire investment. What if the stock jumps up to $100 per share? Then you will have lost $70 per share, more than double your original investment!
Short selling is an important technique for sophisticated investors to use to bet stocks that they feel are overvalued. This created a more liquid market that is better for everyone. However, retail investors should not use short selling unless they are well versed in and prepared for the substantial risks, including losing more than their original investment.