Short selling is a trading technique an investor uses to profit from the falling price of a stock. It is considered a very risky technique as it involves precise timing and because it goes against the overall direction of the market. Stock markets tend to rise in value over time and that is why exact timing is very important as far as short selling is concerned. Retail investors would do well not to engage in short selling.
Short selling: Suppose a trader wants to sell short 100 shares of a company because he thinks sales will fall and earnings decline. His broker then borrows the shares from another trader who owns them with the promise they will be returned later. The trader who has borrowed then sells those shares immediately at the current market price hoping that when the share price drops, he will cover his short position by buying back the shares following which his broker will return them to the lender.
Some risks – unlimited downside potential: If his surmise turns out as expected, he will book a profit, but if he is wrong and share prices go up, the trader’s potential losses are unlimited. At some point he has to replace the 100 shares sold and his losses can increase limitlessly until he covers his short position.
Against market trend: A short seller is going against the trend of the market which, in the long run, is to move up. A trader should buy a stock only when he is sure it is greatly undervalued and should hold on to it only as long as it takes for the dividends to begin showing up. Trading on the short side always means a trader will eventually need to buy the shares back at the existing market price, and while he is forced to wait for speculation to end, the rest of the market probably will have continued upwards.
No interest earned: A seller cannot avail of the money from a short sale, but is in custody as collateral for the owner who lends the shares. Hence, a short seller will not earn any interest on the money.