Short selling refers to the selling of shares not owned by the seller, but are instead usually borrowed. Short selling occurs because an investor believes that the price of a stock will decline, essentially “betting against” a company. This makes short selling an inherently risky practice.
Short selling usually begins with a trader borrowing shares in a company and subsequently selling them. When the trader closes the short position, the trader buys the shares on the open market in order to replace the borrowed shares. Ideally, the trader does this when the price has lowered significantly. For instance, if the trader sold the shares initially for $60 a share, and then closes the short position at $50 a share, than the trader has made a profit of $10 per share. But is the stock rises to $70, the trader will lose $10 a share.
Because there is no limit to how much a stock could rise, short selling has a potential for infinite loss. Closing the short position must be timed carefully before the stock rallies and rises again. Short selling is often criticized as a predatory practice, but it plays an important role in the market, providing liquidity and preventing price spikes driven by over-optimism. Intentionally damaging a company’s reputation in order to short sell is highly illegal, but short selling can be done legally and responsibly as a form of risk management.