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Short sale investing is a technique that investors use to profit when the market or a specific stock is experiencing a decrease in stock prices. When an investor conducts a short sale, it borrows the security from the broker and then sells it. When the investor sells the investment, it is with the knowledge that they will repurchase the security in the future, so that they can then return it to the broker from which they borrowed it.
For example, if an investor believes that the price of XYZ stock is going to decrease, they may short sale some of this stock. An investor enters into short sale investing because they believe that the current price of the stock is too high or overpriced, so they believe it will decline in the near future. The investor in this scenario would contact their broker or an investment broker to retain the shares of the XYZ stock.
If their broker does not have the stock, then this broker may borrow it on the investor’s behalf. As soon as the investor borrows the stock from the broker, they immediately sell it. The investor receives the current market price for the shares of stock that they short. When and if the price of the stock drops, then the investor covers the short when they buy back the shares at the lower price.
Once the investor buys back the shares at the lower price, they then return the shares to the broker from which they originally borrowed the shares of stocks. The investor profits from short sale investing. The profit from a short sale is the difference in the amount they sold the shares of stock for and the price they paid to buy back the stock shares. Of course, the investor must also deduct any broker commissions or expenses for the transactions before calculating the real profit.
An issue arises, however, if the stock price increases rather the decreases. In short sale investing, when the share price does not decline, but instead increases, the amount of money that the investor may lose is limitless. As the price of the stock increases, the investor has to choose the point where they will buy back the shares.
They have to buy back the shares of stock in order to return the stock to the broker they borrowed it from in the first place. The amount of the loss depends on the point in which the investor buys back the stocks. The more the stock price increases, the more the loss to the investor engaged in short sale investing.