Definition of Shorting Stocks

Short selling is a risky investment strategy that involves trading with stocks that are not in the investor's possession. When taking a traditional long position on stocks, where the stocks are purchased and held until the point of sale, the potential gains are unlimited as the stock can continue to grow as time goes by. However, when shorting stocks, the inverse is true: the potential losses are unlimited since a rising stock price equals a loss for the investor.

Short Selling Stocks

Short selling occurs when an investor sells shares of a stock that are not already owned. This is done in the hopes that the stock's price will fall and the investor can then purchase the shares; the difference between the selling and buying price is the investor's profit.

How to Short Stocks

To sell shares short, an investor will open an account with a brokerage firm who then lends the necessary shares from the firm's own holdings or arranges for another brokerage firm to lend the shares. The investor must eventually cover this short by purchasing the number of stocks shorted in order to return them to the original owner.

Restrictions

There are various restrictions on short selling that are put in place by the SEC. Penny stocks are not eligible to be sold short and shorts must be conducted in round lots (usually a multiple of 100).

Types of Investors

Due to the complicated nature of short selling, typically only sophisticated investors such as hedge fund managers and large institutional investors will partake in this type of trading.

Risks

Since the shares of the stock the investor sells are owned by another investor, if the stock pays a dividend, the short seller must reimburse the lender for the total amount of all payouts.