What Is a Stock Short Sale?
Stock short sales are one of the most mysterious and misunderstood aspects of the stock market. It's unfathomable to many just how investors can profit from a stock going down or why they would even want to do that. Many casual investors can't participate in actual short sales, which explains the misunderstanding. In reality, short selling is a form of leverage, which allows a trader to capitalize on her ability to borrow.
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Features
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A short sale is one where the security being sold is not owned by the seller. It is borrowed by her and must be replaced. The seller can profit if the replacement cost of the borrowed stock is less than the proceeds she collects from the sale.
Function
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Short selling is a way to make money from stock prices is going down. Some investors are dedicated exclusively to short selling. Their research is the inverse of long-term only investors. They look for companies losing to their competition and struggling to stay afloat.
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Misconceptions
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A popular misconception is that short sellers destroy value. In fact, short sellers do the market a service by identifying overvalued companies. For example, it was short sellers that first began raising worries over bank balance sheets in 2007, prior to the credit crisis that led to the bankruptcy of Bear Sterns and Lehman Brothers.
Types
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To be legal, a short seller must identify shares of a company to borrow and sell. Naked short selling, though not allowed, tends to happen quite frequently. In naked short selling, the short seller does not sell borrowed shares, artificially inflates the supply of shares. This imbalance in supply and demand can be enough to start or fuel a stock's decline.
Considerations
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The borrowing of shares represents a sort of loan to the short sellers. Thus, most retail investors can only participate in short selling in accounts that are authorized for trading on margin and which are subject to strict rules and margin calls.
Warning
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In theory, there is no limit to the risk short sellers undertake. A stock can only go down to zero, wiping out an investor's entire capital outlay. But there's no upper bound to how high a stock can go to limit the replacement cost to the short seller. As a result, a short seller can find themselves owing substantial sums on a bad trade.
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