Short selling involves borrowing the stock of a company with the expectation of earning a profit later, when the person buys back the stock at a lower price. This strategy is based on the expectation that a company's stock price will decline in the near term. The basic short selling process involves these steps:
- Set up a margin account at a brokerage firm, where the investor uses the value of his investments placed with the brokerage firm to borrow money.
- Place a short sale transaction with the brokerage firm. The short seller is borrowing the target company’s stock from the broker. The broker, in turn, is borrowing the shares either from its own inventory, or another brokerage firm, or the account of another client.
- Wait for the stock price to decline, and then authorize the broker to sell the shares on the open market. The broker also buys shares on the open market to close out the transaction.
Short selling is a very risky activity. For example, if a company’s stock sells for $5 and its price drops all the way to zero, then a short seller can earn a maximum of $5. However, if the price increases to $100, then the short seller has just lost $95. Thus, there is a limited upside potential and a massive downside potential for a short seller.
To increase the risk to a short seller even more, the entity that loans the shares to the short seller can demand that the short position be closed at any time, which means that the short seller must buy shares at whatever the current market price may be and return the shares. The lender (usually a broker) requires the return of its shares when it has concerns about the creditworthiness of the short seller.
Even if a short seller uncovers critical information about a business that absolutely, positively appears to presage a drop in its stock price, it is very difficult to determine when the price change will occur. This increases the risk for a short seller, who may be tempted to keep a short position open for a long time, waiting for the anticipated drop to occur. During that time, the stock price may very well increase instead, which may result in the brokerage imposing a margin call, where the investor must put more funds into his account with the brokerage. Consequently, short sellers also have a timing risk.
In summary, the investments of short sellers can be wiped out from the unlimited nature of short selling losses, by being forced to close out their positions with whichever entity loaned them shares, and because of fluctuations in stock prices while they are waiting for the price of the target stock to decline.