Definition of Shorting
The usual ways of thinking about stocks or commodities is that you buy them at a given price and then you later sell it. Shorting reverses that process. When you short something you borrow the stock or commodity from your broker (at a given interest rate), you then sell it. Later you buy the stock or commodity on the open market and give it to your broker.
Example of Shorting
The investor borrow 100 shares of stock A from their broker and they agree to pay the broker 1 dollar per day in interest. They sell the borrowed shares for 1 dollar each on the open market. 30 days later the price of the stock is 50 cents per share. The investor buys the shares on the open market for 50 cents per shares and gives them to their broker. They made 50 dollars on the transaction (100 – 50). After you subtract the interest (30 dollars) the investor is left with 20 dollars of profit.
The Risk
Shorting is incredibly risky as your potential loss is infinite. If the stock price had risen to 1000 dollars per share, you still would be required to buy the stock on the open market. When you’re required to buy back the shares (whether you want to or not) depends on your account margin. It is simply the ratio between the value of the shorted stock and the value of your account. If that ratio gets too high the broker will demand the shares back.
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Questions for the comments
Did my explanation make sense? Do you agree or disagree with what I said?
