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Most investors purchase securities, hoping they increase in value. Short sellers, on the other hand, bet that a security’s price is about to drop and profit if they are correct.
It works sort of like this. You go to your friend’s house and see that she has a new mountain bike that she paid too much money for. Mind if I borrow your mountain bike, you ask, to which your friend agrees. On the way home you run into another friend, who admires the bike so much that she offers you two thousand dollars for it.
Sold! You take the $2,000 and put it in your pocket.
Wait a minute, that wasn’t even your mountain bike! No problem. A few days later you go to the bike store to replace the borrowed bike, and—as predicted—the price has fallen to just $1,000. Perfect!
You sold the bike for $2,000 and you can get out of your position by paying only $1,000, keeping the $1,000 difference as your profit. Buy the bike for $1,000, wheel it over to your friend to cover the one you borrowed, and everyone is happy.
Notice that you made money when the price went down. Therefore, you were "bearish" on the price of mountain bikes.
Short sellers do not sell bikes or software companies short, but they can sell the stock of companies who make bikes or software short. If investors think Apple or Alpha common stock is overpriced and headed for a drop, they can borrow the shares from their broker-dealers and sell them at what they feel is the top.
However, many people tried that after Facebook went public at $38. When it got to $50, many were convinced the stock would only go down from there, so they sold it short at $50. Expecting to buy it back or “cover their short positions” for less than $50, these traders must have been embarrassed to see the stock soon climb to nearly $200 per-share.
Selling for $50 and buying for $200 is not a good trade. It is no different from buying for $200 and then selling for $50. It is just more dangerous. When we buy, we have already lost all we could ever lose. But when we sell stock short, there is no limit to how much we will have to spend to get out of the position.
Short sellers profit when the price of the stock goes down, but they have limited upside and unlimited risk. If an investor sells a stock short for $5,000, $5,000 is the maximum gain, and only if the stock went to zero. On the other hand, the potential loss is unlimited, since no one can say for sure how high the stock could rise, representing the purchase price.
Stock is not the only thing that can be sold short. Treasury securities are frequently sold short, as are corporate bonds, ETFs (exchange-traded funds), and closed-end funds. Writers of options are “short the option” and complete the trade when they buy it back to close.