Short selling stocks is a method of taking advantage of decreasing share prices in order to realize a profit. In a nut shell shorting is betting against a given security.
A trader will borrow shares from a broker and sell the shares on the market hoping the security loses value, if the stock starts to decline in price the trader can purchase the shares and replace the borrowed stock.
So the net profit is the difference between the initial selling price and purchasing price of the stock to replace the borrowed shares, less any brokerage fees.
A simple formula could look something like this:
Borrowed stock selling price – Replacement value of borrowed shares – Trading fees = Profit.
For example- say a trader researched a tech company and felt that it was wildly overvalued, he/she could decide to borrow shares from their broker.
If the shares were trading at $15 and 100 shares were borrowed, the trader would immediatley sell the shares on the market and deposit $1500 dollars in their account.
Now the trader would wait (and hope) that the share price decreased. For arguments sake say the shares decreased to $7, the trader could purchase the 100 shares and replace the shares, or cover the short, borrowed from the broker. This would cost him $700. Additionally say the sale and purchase of the shares cost $50 dollars in trading fees the formula above would look like this:
$1500 – $700 – $50 = $750.
The trader would realize a profit of $750 dollars.
Lets use the same scenario above with respect to initial sale price and amount of borrowed shares, but instead of having the stock go down in price lets assume, for fun, that Microsoft fell in love with this tech company and wanted to acquire its technology thus offering to pay a hefty premium in order to buy the company, and the shares shot up to $45 dollars. The formula would look like this:
$1500 – $4500 – $50= -$3050.
The trader would suffer a loss of $3050 dollars.
In theory the losses in short selling can be huge and very risky because there is no telling how high a stock may go, while it is foreseeable to see how low a stock can plunge, $0. Many brokers require short selling traders to meet specific financial criteria in order to be given permission to short sell, additionally there are minimum levels of cash required to be allowed to short stocks.This is a very basic introduction to the complex and risky world of short selling; it is important to understand federal and provincial regulations regarding short selling and what is or is not permitted.