Short selling is an investment strategy in which an investor borrows shares from a broker and sells them in the open market, hoping the price will fall. If it does, the investor buys the shares back at the lower price (called "covering"), returns them to the lender, and profits from the difference.
Mechanics: 1. Investor borrows 100 shares of XYZ (currently at $50) from their broker. 2. Investor sells the borrowed shares for $5,000. 3. XYZ falls to $40. Investor buys 100 shares for $4,000 (covers the short). 4. Returns shares to lender. Profit = $5,000 − $4,000 = $1,000 (minus interest and fees).
Key risks: - Unlimited loss potential: If the stock rises instead of falls, the investor must buy back at a higher price. Since there's no ceiling on stock prices, losses are theoretically unlimited. - Short squeeze: If many short sellers are forced to cover simultaneously (stock rising), it can cause a rapid price spike. - Margin requirement: Short positions require a margin account (50% Reg T initial margin; 30% maintenance). - Dividends: Short seller must pay dividends to the lender of the shares.
Regulatory rules: - Regulation SHO: Requires broker-dealers to locate (or have reasonable belief they can borrow) shares before executing a short sale. - Uptick rule (Rule 10a-1/201): Restricts short selling when a stock has declined 10%+ in a single day (circuit breaker).
> Exam tip: Short selling = bearish strategy. Maximum profit = initial sale price (stock can only fall to zero). Maximum loss = unlimited (stock can rise without limit). Requires a margin account.