Every now and then there is some financial news story about someone or some hedge fund that is “shorting” a stock. This esoteric investment strategy involves benefiting when the stock price goes down in value. One might think this technique was born out of the derivatives movement in the late 20th century or made possible by technological advancements in the financial sector, but they would be wrong. Shorting stocks has been around for hundreds of years.
When you short a stock, you are borrowing the shares from someone else (for a fee) and then selling them in the open market. At some point in the future, you buy them back and return them to the original owner. The difference between the price at which you originally sold the shares for and the price you bought them back at is your profit.
The opposite of being short a stock is – you guessed it – being long a stock. Short sellers make up a small minority of the market as most investors are long. After all, it makes sense to be long, your upside potential is technically unlimited. There is no limit to how high a stock price can go and the most you can lose is your initial investment. However, what appears as open skies to the bull is a bottomless pit to the bear. If you are short a stock, then there is no limit to how much money you can lose.
Imagine that you borrowed some shares from me and sold them hoping they would decline in value, a typical bear. Now, let us also imagine that the price does the opposite of what you hoped; they double in value. My sentiment towards those shares has now changed. If you’d like to continue to borrow this highly appreciated asset you will have to make it worth my while or else give them back to me! In other words, either put up some cash or exit your position. If the share price continues to climb you will have to put up more and more money to continue your bear quest. Therefore, there is no limit to how much money you can lose when you are short a stock. This is precisely why shorting stocks is so risky.