How Markets Work · Intermediate · 5 min

Short selling explained

You can explain how a short sale works, calculate its profit or loss, and name the costs and risks that make it different from buying.

Selling what you don't own

Most people can only gain from a share when its price rises. Short selling turns that around. It lets traders profit when a price falls, by selling first and buying later.

It sounds like a simple mirror image of buying. It is not. The order of the steps changes the risk completely, and that is the part every beginner needs to understand before going near it.

How a short sale works

Short selling means selling shares you have borrowed, in the hope of buying them back later at a lower price.

You borrow shares, usually from your broker. Brokers lend from their own stock, from other customers' margin accounts or from other lenders.
You sell them right away at the current price.
Later you buy the same number of shares back on the market.
You return them to the lender.

If the price fell in between, you keep the difference. If it rose, you pay the difference.

The risk is not symmetric. When you buy a share, the worst case is that it falls to zero and you lose what you paid. When you short a share, the SEC warns that you are open to unlimited losses, because a price can, in theory, keep rising forever. Your possible gain, on the other hand, is capped: the price can fall only to zero.

Short selling also has running costs:

Interest on the borrowed shares, which can be high for shares that are hard to borrow.
Dividends: if the company pays one while you are short, you pay it to the lender.
Margin: short sales run through a margin account, and your broker can demand more money or close the position if the price rises.

Many private traders never borrow shares directly. They take short positions through CFDs or other derivatives, which bring the same open-ended risk plus leverage.

60, then 40, or 80

This follows the SEC's own example. A fictional company trades at 60. You expect it to fall, borrow 100 shares and sell them at 60.

The price falls to 40. You buy back 100 shares for 4,000 and return them. You sold for 6,000, so you gain 2,000, minus interest and fees.
The price rises to 80. You have to pay 8,000 to buy back. The loss is 2,000, plus costs.

And if the price had risen to 120, the loss would be 6,000, the full amount you received when you sold. Every further point up adds another 100 to the loss.

Common mistakes

"It's just buying in reverse." The loss of a short position has no ceiling.
Ignoring the costs. Interest and dividends add up the longer you hold.
Shorting without a stop. A rising price can turn a small loss into a large one quickly, and gaps make stops slip.
Underestimating a short squeeze. When many short sellers rush to buy back at once, their buying can drive the price even higher.

The takeaway

Short selling profits from falling prices by selling borrowed shares first. The gain is capped, the possible loss is not.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the line that shows a short position.

Tap the chart.

The short line gains when the price falls below 60 and loses more and more as the price rises.
2You short a share at 60 and buy it back at 80. What is the result per share, before costs?

You sold at 60 and had to pay 80 to buy back: 60 − 80 = −20. This is the SEC's own example.
3Why is the possible loss of a short position unlimited?

A long position can lose at most what you paid. A short position loses more with every point the price rises.
4The company pays a dividend while you are short its shares. Who pays it to the lender?

The SEC notes that the short seller must pay the dividend to the person or firm that lent the shares.

of 4 correct.