The Other Side Of Short Selling

Filed under: Questions from You

Ed. This item has been substantially corrected.

Our Twitter pal @imajes sent in a question:

"In a short-selling scenario, what does the person loaning the stock have to gain?"

Briefly, short-selling stock is a technique used by investors who try to profit from the falling price of a stock.Short selling may sound confusing, but it's actually a simple, if risky, investing strategy.

Say you decide to short a stock. First, it you don't have to own a stock to "short" it. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.

When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. How much you make or lose from here depends on what happens to the stock's price.

If the price of the shares drops, you have to "cover" your bet by buying back the shares, and the broker returns them to the lender. Your profit is the difference between the price at which the stock was sold and the cost to buy it back.

But here's your risk. If the price of the shares increases, you have to buy it back at the higher price, and you lose money. Whoever loaned the shares can make out big. If, say, the stock rises 100%, they just made a lot of money.

Daniel Costello

11:10 AM ET | 01-14-2009 | permalink

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