A situation in which an investor sells borrowed securities, expecting prices to decline, and is required to return an equal number of shares at some future date. A short seller will make money if the stock goes down in price, while a long position makes money when the stock goes up. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares.
Here’s how it works. Generally, brokers borrow shares of securities from fund management companies and custody banks, which lend them out as a source of revenue. The broker then allows investors to sell the borrowed stock for a short period of time (often a few months).
The goal of a short sale is to make money off of a stock that may soon be dropping in price. The investor essentially makes a bet that he can sell a stock at its current price and buy it back at a lower price a short while later. If successful, he returns the stock shares to the broker and pockets the difference between the original selling price and the subsequent buyback price.
Short selling is a risky proposition, and novice investors probably shouldn’t try it. Ironically, the potential danger is related to the stock increasing in value rather than decreasing. If the price goes up, the investor needs to buy it back at the higher price and takes a loss equal to the increase multiplied by the number of shares.
An investor borrows 500 shares of a tech stock and sells for $40 per share. The sale proceeds total $20,000. A couple months later, the stock price has dropped to $32 per share, and the investor buys back 500 shares for just $16,000. He returns the shares to the broker and keeps the $4,000 profit from the short sale.