Selling short is much more complicated than a normal transaction and as such there is more risk involved. To ensure that you make money, you have to be certain that the stock’s value will continue to drop or you will lose money. But, there is the opportunity here to make a lot of money.
Normally when you buy a stock you are buying a partial ownership in a company. There are two ways you purchase stock, either directly from the company or through a stock broker. Most people use brokers; they are a sort of go-between for the investor and the seller and for their service they charge a fee.
In order to use a broker it is normal practice to set up an account with them. There are two kinds of accounts, either a cash account or a margin account. For selling short you’re going to want a margin account. The reason for this is that with a margin account, instead of purchasing your stock outright, the broker lends you the funds to buy the stock and the stock then functions as collateral for the purchase. Normally if you were to go long you buy the stock believing its value will increase in the future. When going short you’re counting on the price dropping.
When you sell short, the advantage is that you don’t specifically own the stock you sell, so as the seller, you are selling a stock which you don’t own. (You have been loaned the money through the margin account with your broker). So, you sell those stocks you don’t own and the proceeds from the sale go into your account. Now, because you have to close this account you are expected to buy the shares back – the same number of shares you sold earlier. These must be returned to your broker (this is referred to as “covering”). Now, when you buy them back, and if the price has dropped you are now buying them at a lower price and making a profit from the difference. If the price increases on these stocks, when you buy them back you are going to lose money, which is why this can be a risky venture.