The answer to the question “what is short selling stock” is that profitable short selling requires superhuman timing—and the inevitable mistakes can be super expensive for investors.

What is short selling stock? Short selling is when you borrow stock through your broker and then sell it right away. However, you eventually have to return the borrowed shares, so you will have to buy back the stock on the market. If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, you must buy it back at a higher price than you sold it at. You then lose money.

On the other hand, when you buy high-quality stocks and diversify, you tend to profit automatically over time. That’s because well-run companies tend to profit over long periods due to economic growth, population gains, improving technology and productivity and so on. (That’s why we recommend that you buy high-quality stocks and diversify across most if not all of the five main economic sectors…more on that below.)

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What is short selling stock? Basically, pure speculation

Short selling is pure speculation. It’s what a mathematician calls a “negative sum game,” since the winners have to outguess the losers by a large enough factor to pay associated costs. It doesn’t enjoy any of the advantages of conservative investing. Profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive for investors.

As a general rule, we advise against short selling much as we advise against options trading, leverage, currency speculation and bond trading. In all these activities, it’s a rare investor who makes enough profit to compensate for the risk involved.

What is short selling stock? A quick way to heighten your risk

Before you sell a stock short, your broker has to be able to borrow the stock. The stock lender can demand the return of the stock with little notice. Failing or troubled stocks can go through stunning but temporary “rallies” or stock-price increases. When you sell a stock short and it rallies, you have to put up additional cash with the broker, so there is enough value in your account to “cover” your short—that is, buy the stock back and return it to the lender.

If the lender demands return of the stock, and your broker can’t find another lender of the stock, you have to buy it back in the market. If you and other “shorts” are bidding against each other because your borrowed stock has been “called” by its owner, the stock can soar.

What is short selling stock? A way to risk unlimited losses

It’s easy for a short seller to be right in the long term on the low quality of a bad stock, but to lose money anyway. That can happen because the stock lender has demanded the return of the stock, or because the short seller has run out of cash, or simply because the short seller doesn’t want to risk any further losses.

As a short seller, your losses are virtually unlimited. After all, there is no limit on how high a stock can rise, regardless of its fundamentals. But the gain is limited to 100%, if the stock you’ve shorted goes to zero.

For buyers, the situation is reversed. Gains are virtually unlimited for stock buyers, since there is no limit on how high a stock can rise, regardless of its fundamentals. But the most a buyer can lose is 100%, if the stock goes to zero.

Use our three-part Successful Investor approach Instead of short selling stock

1. Invest mainly in well-established, mostly dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Investors who practice short selling usually do it to make fast money. Has this approach ever worked for you?

Why do you think some investors get into short selling, despite the risks?