If you have taken an investment course or studied investments, you probably have been exposed to the idea of short selling. Nonetheless, the concept is not too straightforward and a little review is always beneficial.
A typical transaction in the stock market involves one party buying stock from another party. It is possible, however, that the party selling the stock does not actually own the stock. That party could borrow the stock from a broker. That person is said to be selling short.
He is doing so in anticipation that the price of that stock will fall in the future, at which time the short seller would buy back the stock at that lowered price, making a profit and returning the stock to the broker.
You may have heard the expression “Don’t sell yourself short” which simply means not to view yourself as being less talented or less correct than someone else.
Similarly the short seller views the stock as being worth less than the current market price.
Establishing a short position creates a liability. The short seller has to someday in future buy back the stock and level his position.
Unlike an ordinary loan in which the borrower knows exactly how much he would be required to pay back, the short seller does not have any idea how much will he be required to pay to buy back his shares. But he has entered this (short) position in anticipation that the price of that stock will fall in the future when he can buy them back and make a profit. This makes it risky. Indeed short selling is a very daring investment strategy.
Short selling, however, can be quite beneficial in that the risk of short position can be useful in offsetting the risk of long positions. The short selling of derivatives is particularly helpful. It is common to find an investor holding a stock and protecting it by selling short a derivative.
Note: Please see the video below on Basic Short Selling Scenario: