Short sales

Investors can potentially profit in different market conditions. Many investors earn returns when prices rise, but you can also try to profit when prices fall. Selling short is a strategy that lets an investor bet against a security and potentially make money if its market value declines.

Selling short is more complex than going long (buying) a security. You’ll work with your broker-dealer to confirm the firm can access (locate) the security you want to sell short. The basic steps look like this:

• The investor borrows the security through the brokerage firm and agrees to return it at a later date.
• The investor sells the borrowed security in the market right away.

After the sale, the investor hopes the market price falls. At some point, the investor must buy the security back and return it to the broker-dealer. The lower the repurchase price, the higher the potential profit.

For example, an investor sells short stock for $75. A few weeks later, the stock falls, and the investor repurchases the stock at $60 to lock in a $15 per share profit.

Sometimes an analogy makes short sales easier to picture. Imagine you believe the price of a concert ticket will fall because demand is weak, and you want to profit from that drop. If a friend has a ticket, you could borrow it and promise to return it before the concert. After borrowing the ticket, you sell it online for $50.

Now suppose you were right: demand is underwhelming, and tickets are selling for $40 the day before the concert. You buy a ticket for $40 and return it to your friend. You’ve made a $10 profit from the price falling. Selling short works the same way.

Selling short comes with significant risk and can lead to large losses if the market price rises instead of falls. For example, suppose you sold short stock (or a concert ticket) for $50 because you expected demand to fall. Instead, demand surges and the market price rises to $200. If you buy back at $200, you would have a $150 loss (per share or ticket).

A key risk is that there’s no ceiling on how high a market price can go. Prices can rise without limit, which means the repurchase cost can also rise without limit. The higher the price, the more expensive it is to buy back the security, and the larger the potential loss.

Selling short securities is risky, but it can provide a way to potentially profit in a bear (falling) market. Only the most sophisticated (knowledgeable and wealthy) investors should consider selling short.