When an investor believes that a specific asset is likely to lose value, he may take a short position on that asset. This may be accomplished by short selling the asset or by writing an option on the asset. Short selling is the practice of borrowing an asset, such as a number of stock shares, and then selling the asset to someone else at the current price. If the price of the shares drops after the sale, the investor then purchases the same number of shares back at the lower price, returns the shares to the lender, and pockets the difference between the higher and lower prices. Alternatively, an investor who owns an asset may enter into a contract with another party for the sale of those shares at a set price on a future date, thereby insulating the owner from losses.
For example, an investor may believe that stock prices for Company X will go down. He sets up a margin account with a brokerage firm, which is an account that allows an investor to borrow the purchase price from the brokerage with the security acting as collateral. The investor orders 100 shares of Company X stock at $50 US Dollars (USD) per share, which he then sells at that price. When the share price drops to $35 USD per share, the investor purchases the 100 shares and returns them to the brokerage.
By short selling, the investor in the example has increased his portfolio value by almost $1,500 USD. He sold the borrowed assets for $5,000 USD and covered the stocks he owed by paying $3,500 USD. The difference between the two amounts, minus the interest on the margin account, is his profit. Covering a short is the process of buying the same number of shares to return them to the brokerage or lender.
When an investor takes a short position, the brokerage obtains the asset from its own inventory, from another brokerage, or from one of its other customers. Under most circumstances, the investor may keep the short open as long as he desires. In addition to the accruing interest on the margin account, a risk of keeping a short open is that the lender may demand the return of the borrowed asset at any time. The brokerage might be able to borrow other shares, but if it cannot, the investor has to cover immediately. This process is called being called away.
Taking a short position for speculative reasons carries significant risk. Short selling gambles on the value of an asset decreasing over time. If the price goes up instead, the losses can exceed the initial investment many times over. In the example above, if the stock price rose to $75 USD per share from the initial $50 USD per share, the investor would lose $2,500 USD on the deal. The most that the investor can gain from a short position is 100 percent of the initial investment, but his losses can be unlimited, theoretically.
When many investors take a short position on the same stock, if the stock price rises, there can be a massive rush on the market by short sellers to cover their positions. The increased demand drives the price higher, an event known as a short squeeze. This can prompt lenders of the stock to call away the short sellers, requiring immediate purchase and return of the stocks. A short squeeze can result in a massive loss for the short seller.