Short Selling Stocks, Who Uses It, Pros, and Cons
Short selling stocks is when you sell shares that you don't actually own. How can you do this? Your stock broker buys the stock. He or she then lends it to you, sells it, and credits your account with the proceeds. You promise to buy the stock sometime in the future to return the loan. This is called covering the short.
Why would your broker be so nice? First, you pay him or her a small fee for the transaction. You also pay the broker any dividends paid out by the stock that is borrowed. You hope the stock price plummets in a short time, so you can make a profit. If the stock price remains the same, you are out the fee. If the stock price rises, you are out the higher stock price and the fee.
The broker is guaranteed the fee. In addition, the broker can force you to cover the short at any time. That means you would have to buy the stock at that day's price so you could return it to your broker. If the stock price happens to be higher on that day than the day your broker lent it to you, you are out the difference. The broker would only ask you to cover the short if many investors were short selling your stock, and the broker needed it to lend to them! So, if this happens, you are pretty much guaranteed the price will be higher than what you "sold" it for.
Short-selling can make stock prices rise temporarily on a stock that's really of low value. If everyone thinks the stock price is falling, and there is a run on shorting the stock, short covering can actually make the stock price go up. (Source: Securities and Exchange Commission, Short Sale)
Hedge Funds Are the Biggest Users of Short Sales
Hedge funds use short selling to profit during a stock bear market or even a stock market crash. That's because the fund can sell the stock when it's high, and buy it when it's low. Hedge funds like short sales because they get the money up front, from selling the stock they've borrowed from the broker. In effect, their only up-front risk is the fee paid for the short sale transaction.
This leverage allows hedge funds to make a lot of money when they are right. If they are wrong, they are also very wrong. But hedge fund managers generally don't use their own money, so if they're wrong, they don't pay for their mistake with their own money. If they're right, they get paid a percentage of the profit. This compensation system rewards them for taking outsize risks.
Until the Dodd-Frank Wall Street Reform Act, hedge funds weren't regulated. This meant they didn't have to tell their investors what they were doing, or how much money they lost. The investors basically put the money into a black box. If the hedge fund made more than they lost over the long run, the investors were happy.
Like other types of derivatives, short sales allows you to potentially reap a large return without putting much money up front. You only have to invest the fee to your broker. If you're right, and the stock price plunges, the rest is all profit.
Second, shorting a stock is one of the few ways to make money in a bear market.
Third, shorting can hedge your investment if you already own the stock, didn't sell it before the downturn, and think it will only lose value. You can short it, and at least profit from the remaining downturn.
Shorting only makes money if the stock price goes down. If you're wrong, and the price rises, you are out the difference. The real risk is your loss is potentially limitless. If the price skyrockets, you have to buy it at that price to return the stock to your broker. There is no limit to your loss.
Short selling has even worse implications for the stock market as a whole, and therefore the economy. It can take a normal stock market dip and turn it into a crash. If a lot of investors or hedge fund managers decide to short a particular company's stock, they can literally force the company to go bankrupt. Many experts say short selling helped cause the demise of Bear Stearns in the spring of 2008, and Fannie Mae and Freddie Mac later that summer. When short sellers went after Lehman Brothers in the fall, it was enough to set off a panic. It created a huge crash, signaling the financial crisis of 2008.