Investors that buy a stock typically do so in the hope that they can sell the stock at a higher price sometime in the future. Short selling is the opposite of buying a stock. An investor sells the share today in the hope that they can buy it back in the future at a cheaper price and therefore make a profit.
1. To sell a share short, you need to be able to borrow the stock
2. When you short sell a stock your downside (potential loss) is theoretically unlimited, while your upside/profit is capped to the amount that the current share price goes to zero. When you buy a stock, the opposite is true. Your upside is unlimited while your downside is capped to the amount you originally invested.
Given that short sales signify that some investors think the price of the stock will decline in the future, it suggests that there are some underlying economic reasons that these short sellers think the share price is currently overvalued. However, short sellers are not always right. If the company is actually in a far better position than the short sellers have anticipated, then eventually more investors will buy the stock which is likely to cause the price to rise and force the short sellers to cover their position. In order to do this, the short seller must enter the market and repurchase the shares that they previously sold and by doing so creating further demand for the stock. In this way there is potential for large gains for longer-term investors who bet that the company can turn their current misfortunes around.
Is short selling bad for markets and investors?
Short selling in theory is not bad for markets. It arguably leads to an efficient market where price equilibrium is obtained more quickly. They help to prevent shares prices valuations becoming unrealistic and consequently creating stock market bubbles. However, short sellers can also cause a lot of problems for the listed companies. By short selling stock they may be able to influence other investors into selling despite there being little reason to. This can create panic and investors lose confidence in the stock. However, there may be little or no fundamental reason to do so. In this way, large hedge funds and fund managers can “bully” smaller investors into selling as they see the share price falling and decide to sell on price reaction rather than any fundamental reason. Small investors need to protect themselves by arming themselves with knowledge and ensuring that they have a strong understanding of all factors, both good and bad of why the stock price is moving.