Example of short selling
Let’s say that the shares of company ABC are currently trading at £75, but you believe that they are going to decline in value and decide to short sell the stock. You borrow 100 shares of ABC from your broker and sell them on the open market.
Over the next week the market drops significantly down to £40, so you close your short position and buy back 100 shares of ABC at £40 each.
You calculate the difference between the price of the shares when you borrowed them (75 x 100 = £7500) and the price that you re-bought the shares for (40 x 100 = 4000), which gives you a profit of £3500 – excluding any costs your broker may charge.
However, if you had been incorrect and the market had continued to rise, your potential risk is infinite. Because you have borrowed the stock, your broker may ask for them back at any time and you would have to close out your position at a loss.