Short selling is the act of selling stocks that you don’t actually own. As a general rule, an investor would only short sell their stocks if they anticipate that the price of the stock is going to (temporarily) plummet. By selling it before the price drops, they can buy it back later when it’s even less expensive and pocket the difference as profit. Short selling can be a very lucrative practice if you have a time machine. For anyone without a time machine, it’s a risky strategy because it could bring about infinite loss, since any stock could theoretically continue to gain value indefinitely. But when you buy a stock, the most you can lose is the price you paid for it.
Don’t get it? Here’s an example. Your best friend is hosting a house-warming party. Around 1am the party is still swinging, but unfortunately the alcohol has run out. Worse yet, your best friend is asleep and all of the liquor stores are closed. You could go home, but you have a better idea… Since you know where your friend hides his beer stash, you decide to sell bottles of beer for $5 each. It’s a perfect plan because you know the actual cost of the beer is only $2 at the store. So you make $3 profit for every beer you sell. You manage to sell 15 bottles, putting an easy $75 in your pocket. But don’t forget – you still owe your sleeping friend 15 beers. At the crack of dawn, you buy the 15 beers at $2 apiece and replenish your hoodwinked friends stash. By short selling your friends beers, you earned $45 on something you never owned in the first place.Go back to the encyclopedia index