How does short selling actually work mechanically? What are the risks?

Short selling is betting that a stock's price will decline. The mechanics are unintuitive at first, so let's walk through every step.

The Mechanics:

Step by step:

1. Kai borrows 500 shares from a willing lender (usually an institutional investor) through his broker
2. Kai immediately sells the borrowed shares at $60, receiving $30,000
3. Kai waits for the price to drop
4. Kai buys back ("covers") 500 shares at $45, paying $22,500
5. Kai returns the 500 shares to the lender
6. Profit: $30,000 - $22,500 = $7,500 (minus borrowing fees and dividends owed)

Critical Risks:

1. Unlimited loss potential: If the stock rises to $120, Kai loses ($120 - $60) x 500 = $30,000. If it rises to $200, he loses $70,000. There's no ceiling on how high a stock can go.
2. Short squeeze: If many shorts try to cover simultaneously, buying pressure drives the price higher, forcing more covering — a vicious cycle.
3. Dividend obligation: The short seller must pay any dividends to the share lender.
4. Recall risk: The lender can recall shares at any time, forcing the short seller to cover at potentially unfavorable prices.
5. Margin requirements: Short sellers must post margin (typically 50% initial, 30% maintenance).

Key difference from long positions:

• Long: Maximum loss = 100% (stock goes to $0). Maximum gain = unlimited.
• Short: Maximum gain = 100% (stock goes to $0). Maximum loss = unlimited.

Exam tip: The CFA exam tests understanding that short selling has asymmetric risk — limited upside, unlimited downside. Also know that the proceeds from the short sale are held as collateral, not available for the trader to spend.

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