This requires that you borrow the shares and then sell them on the stock market when you think their price is going to fall. If it does, you can buy the shares, hand them back to your broker and pocket the difference (minus loan interest). It’s a risky business.
Short sellers are well-known for channelling the irrational exuberance of a boom – and keeping it in check – while calling out exploitative behaviour, but they do have some serious downsides as well.
Profits
High returns can be gained in short selling, as one can profit from the share price falling, but it is a very risky strategy; careful analysis of the market is needed to anticipate the weaknesses in stocks. Plus, borrowed shares (to enable the selling) must be paid for, including interest (margin interest) on the borrowing, at usually a high rate, which eats into any profits.
Long-con short sellers who are trying to profit from long-term market declines can be similarly thwarted, because bad news and its potential effects on share prices tends to pop up suddenly – and gets priced into shares right away. So if a short seller can’t profit from those fluctuations by shorting as a form of speculation – perhaps selling their short sales premiums, bringing in cash that can be used to offset losses realised in the longs, or that just buys them more margin to make more trades – they eventually would have to buy back their borrowed shares at some cheaper price to close their position, getting to keep any difference, plus loan interest, for themselves.
Losses
To short-sell a share is to bet that its price is going to fall and, if you don’t get the timing right, the losses could be heavy, necessitating not only research but also risk-management. For those who successfully close out a short position (buy back as many of the shares they borrowed as they sold) before the price starts to rise again, the rewards can be great.
Not only do short sellers need to find the borrowed shares from brokers but they also have to pay considerable costs in the process. This cost can easily offset their gains.
Shorting can offset long positions, bring in extra equity to use for margin trades, and profit on overvalued stocks. Shorting can also help canny traders root out companies that produce false price inflation; Schultz used share lending data to track whether companies borrowed shares to inflate returns on stocks; if this was impossible or difficult to do, he found evidence that these stocks might have been overpriced.
Margin requirements
Another key part of this trading mechanics is margin requirements – the sums users have to keep in their accounts in order to not receive margin calls while making higher profits. Generally, exchanges or brokers set these levels of margin requirements based on certain factors such as a share price, its volatility, or the strike price/expiration date combination, which in turn may increase the potential losses.
Short selling, given that the loss on a sold security can be theoretically infinite if such price increases rapidly, can be a very risky strategy, I myself easily could fall into best naked short. Consequently, an investor has to calculate an intrinsic value of the stock breifly and regularly, in order not to make any margin call. One also has to choose a broker with an acceptable margin and desire to provide low commission.
Timeframes
Like any other investment strategy, short selling can be profitable or risky, therefore traders who are involved in this type of investment should stay alert and do intensive research before they buy anything.
Traders tend to go short stocks they think are overpriced; if that proves to be the case, they expect those prices to come down. They will screen for candidates through fundamental or technical analysis, such as looking for companies which have seen their earnings per share or sales growth slow, and hence will likely see a decrease in their share prices.
Fortunately, shorting can be a good thing – if not too many traders decide to do only that, and drag down those vulnerable stock prices. So to limit its harmful impact, regulators instated rules such as the uptick rule, making it illegal to sell shares short unless their price had first gone up.