Short stock sales are a form of stock sale in which the seller offers for sale shares they do not own and then purchases replacement shares when the value of the stock declines. The latter purchase is called covering a short or closing a position. This type of stock trading option is exercised by investors who believe the stock will be devalued in the near future.
Short stock sales are the polar opposite of traditional stock investing. In traditional stock market trading, the investor purchases stocks with the idea that the value of the shares will increase over time. Depending upon the market and the type of share, this may be a rapid increase or a slow, steady growth. Short selling is primarily intended as a short-term investment and is common among day traders, individuals who buy and sell stocks within the same trading day.
In practice, short stock sales, or short selling, allow the investor to sell securities borrowed from a brokerage firm at a premium price. The investor makes money when the stock sees a decline in value. While the investor sells the stocks at a higher price, they buy replacement stocks at a lower cost.
For example, an investor might notice a trend in the market that leads them to believe the value of stock issued by company A will soon plummet from a current price of $100 U.S. Dollars (USD), or about 62 British pound sterling (GBP). The investor contacts the brokerage firm and arranges a short sell order. The firm sells the borrowed stock at the current price for the investor with the understanding that he or she will buy replacement shares at a later date.
If the price of the stock immediately bottoms out to just $1 USD (about 0.62 GBP), the investor covers the short stock sales by replacing the borrowed shares at this price. In this non-typical example, the investor would realize a profit of $99 USD, or about 61 GBP, per share minus brokerage fees. This method of short stock sales makes it possible for investors to earn money on falling shares in bear markets.
While it is possible to make money though short stock sales, the option also has risks. If the value of the stock increases rather than decreases, the investor is still liable for the replacement of the borrowed stock. Many stock brokerage companies limit the use of short stock sales to investors with a proven investment record or funds deposited with the brokerage firm.