With all of the recent volatility in the stock market, I thought I’d talk a bit a bit about a turn of phrase — “shorting” a stock — that I’ve heard quite often over the past few weeks.
Shorting a stock (or executing a “short sale“) essentially involves borrowing shares of a stock such that you can sell them at today’s price. You then buy them back at some (hoepfully lower) future price point and pay back the borrowed shares. This is a relatively common (though potentially risky) technique that is used to make money in a falling market.
Think about it… Let’s say you believe that Company X is overvalued and set to take a tumble. If you borrow 100 shares and sell them at today’s market price (say, $10/share), you’ll pocket $1, 000. If you were right, and the share price falls to, say, $6/share, you can buy back 100 shares for $600, resulting in a $400 profit (ignoring commissions and fees).
The downside is that the stock might go up, at which point you’ll have to buy the shares back for more than you sold them, resulting in a potentially substantial loss.
The real risk here is that the downside potential (and hence your gain) is limited — after all, a stock can’t fall below zero. But the upside potential is (theoretically) unlimited, meaning that you could take a beating if the share prices skyrocket.