Short selling is a way to try to profit when a stock falls instead of when it rises. You borrow shares you do not own, sell them at today's price, and aim to buy them back later at a lower price to return to the lender, pocketing the difference. If the price falls, you gain. If it rises, you lose, and the loss has no fixed ceiling.

That last point is what makes short selling fundamentally different from buying a stock, and it is where most of the risk lives. This explainer walks through how the trade actually works, what it costs, and why a short squeeze can be so punishing.

How the trade works, step by step

A short sale has four stages. First, your broker locates shares to borrow, often from its own inventory, from other clients' margin accounts, or from an outside lender. Second, you sell those borrowed shares on the open market and receive the cash. Third, at some later point you buy the same number of shares back, which is called covering. Fourth, you return the shares to the lender and keep whatever is left.

Say you short 100 shares of a stock at $50, for $5,000. If the price later falls to $30, you buy the shares back for $3,000 and return them, keeping $2,000 before costs. If instead the price goes to $70, buying back costs $7,000, and you are down $2,000. The arithmetic is simple, but the risk is not symmetric, which the next section explains.

Why the losses can be unlimited

When you buy a stock, the worst case is that it goes to zero and you lose what you put in. Your downside is capped. When you short a stock, the worst case is open ended, because there is no limit to how high a price can climb, and the higher it goes, the more it costs you to buy the shares back. The US Securities and Exchange Commission makes this point directly in its investor material on short sales: a short seller's potential losses are not limited the way a buyer's are.

This asymmetry is the single most important thing to understand. A bet against a stock can cost far more than the money you first received, which almost never happens when you simply buy and hold. A trader who shorts at $50 and watches the stock triple to $150 is out $100 a share, twice the cash the sale brought in, and the position can keep bleeding from there if they cannot or do not close it.

What it costs: margin, borrow fees and dividends

Short selling requires a margin account, and the rules are stricter than for ordinary buying. Under the Federal Reserve's Regulation T, opening a short position requires margin equal to 150% of the sale's value, which is the full proceeds of the sale plus an additional 50%. Shorting $20,000 of stock therefore ties up $30,000 in the account. After that, FINRA's maintenance rules generally require equity of at least 30% of the position's current market value for stocks priced at $5 or more, and brokers often impose stricter house requirements.

There are other costs. You pay a borrow fee to the share lender, and hard to borrow stocks can carry steep fees. You also owe the lender any dividends the stock pays while you are short. Those costs run against you the whole time the position is open, which is why shorting is a poor fit for a slow, patient bet.

Timing is the hidden enemy here. A buy and hold investor can wait out a bad stretch at no extra cost beyond opportunity. A short seller pays to wait, through borrow fees and margin tied up, and can be forced out before the thesis plays out even if it eventually proves right. Being correct about a company but early about the timing is a common and expensive way to lose money on a short.

The short squeeze

A short squeeze is the scenario short sellers fear most. When many traders are short the same stock and the price starts to rise, each of them faces mounting losses and margin calls. To cap the damage, they buy shares to cover, but that buying itself pushes the price higher, which forces more short sellers to cover, which drives the price higher still. The cycle feeds on itself. The GameStop episode in January 2021 is the best known example, when a heavily shorted stock soared as shorts scrambled to cover.

Lenders can also recall their shares, and a broker can force a buy in, closing your position at the market price whether you want to or not. In a squeeze, that can happen at the worst possible moment.

How to think about it

Short selling is a legitimate part of markets. It adds liquidity, helps prices reflect bad news, and sometimes exposes fraud. It is also regulated, including under the SEC's Regulation SHO, which sets locate and close out requirements to curb abusive practices. For a sense of how short sellers fit into the wider market mood, our piece on bull versus bear markets covers the backdrop, and the VIX, the market's fear gauge, tracks the volatility that squeezes feed on.

None of this is advice to short anything. The point is that short selling carries uncapped loss potential, ongoing costs and the risk of a forced exit, a profile very different from buying a stock. Understanding that profile is the first step, whether or not you ever place the trade.