Your feedback is essential to help us improve - click here to take our 3 minute survey.

The real risks of short selling stocks

The real risks of short selling stocks
Source: Getty Images

Most people’s investing strategy involves buying stocks expecting that they will increase in value, after which they can then sell them at a profit. But did you know that it’s also possible to make a profit when the price of a stock is falling? This is through a procedure known as short selling.

Here’s everything you need to know about short selling, including the kind of investors who typically do it and, most importantly, the risks involved.

What is short selling?

In simple terms, short selling is an investing strategy that involves speculating a fall in stock prices. The idea is to sell the stocks at the current higher price and then buy them later at a lower price.

Here’s how it goes down.

A short seller borrows shares from a brokerage after speculating that their prices will fall and then sells them immediately. When the price of the shares declines, the short seller buys them to replace the ones they borrowed and hands them back to the brokerage.

The short seller’s profit in this scenario is the difference between the higher sales price of the shares and the lower purchase price (minus any commissions or fees).

What kind of investors short sell stocks?

Short selling is mainly the business of experienced traders and investors. These are people with great knowledge of the market and individual companies, and who can make reasonably accurate projections about the direction of stock prices.

What are the risks?

The biggest risk of short selling stock is that the potential loss is infinite if you make the wrong call.

When you buy an individual stock, the lowest it can fall is zero. That means the maximum loss you can suffer is the amount you paid to purchase the stock.

However, if a stock is sold short, the price could rise and continue going up indefinitely. Basically, there is no upper limit for a stock’s price. This means that as the price rises, your exposure to losses is unlimited.

For example, let’s say you short sell 100 shares of stock at £5 per share. The proceeds from the sale will be £500. If the shares price falls to £1, that means you can buy the same number of shares for £100, making a profit of £400.

But suppose that instead of falling, the price soars to £50 per share. Now, to buy your 100 shares back, you will have to cough up £5,000. That means you’ll have made a net loss of £4500. As you can see, the potential for loss with short selling is significant.

But with that said, short selling can be an excellent opportunity to rake in huge profits in the short term if you are able to make the right call about a stock’s price trajectory.

By doing your homework and using your experience, you may find that you can predict when a stock is due to fall and then take action to profit from this high-risk, high-reward trading strategy.

What are the rules and conditions for buying stock to short sell?

The rules and conditions for borrowing stock to short sell vary from broker to broker. Some might require you to pay borrowing fees as well as any dividends paid by the borrowed stock.

To shield themselves from the risk, some brokers might also require you to leave the proceeds derived from the short sale in an account with them. Others might ask you to first put up additional cash to act as a cushion in case the price of the stock you short sell goes up.

Brokerages are also subject to the Short Selling Regulation (SSR), which gives the FCA the right to suspend short selling or limit transactions when the price of shares and other trade instruments fall by set percentage amounts from the previous day’s closing price. 

So, should you short sell stock?

Short selling is a tricky business and is perhaps best left to experienced investors. It’s not recommended for novices – even the most experienced investors sometimes struggle with it.

For most investors, buying stocks and holding them for the long term is a much safer bet than short selling. Stock prices may fall once in a while but over the long term, the market has a significant upward bias.

Rated 5 stars out of 5 by The Motley Fool UK

Trade UK shares for just £2.95 and US shares for just $3.95 — with no platform fee!

The FinecoBank* Multi-Currency Trading Account offers UK investors highly competitive share-dealing rates across 26 global markets. Open your account using promo code TRD500-ML and during your first 3 months you can trade without incurring commission charges – up to a total commission amount of £500. (Terms and conditions apply.)

*Affiliate Partner. Important information and risk disclaimer: The value of shares and any income produced can fall as well as rise, and you may get back less than you invest. Exchange rate fluctuations can reduce the sterling value of any overseas holdings.

Was this article helpful?

Some offers on The Motley Fool UK site are from our partners — it’s how we make money and keep this site going. But does that impact our ratings? Nope. Our commitment is to you. If a product isn’t any good, our rating will reflect that, or we won’t list it at all. Also, while we aim to feature the best products available, we do not review every product on the market. Learn more here. The statements above are The Motley Fool’s alone and have not been provided or endorsed by bank advertisers. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK has recommended Barclays, Hargreaves Lansdown, HSBC Holdings, Lloyds Banking Group, Mastercard, and Tesco.