Shorting stocks successfully requires a steady hand and an excellent understanding of the inner workings of the stock market. In order to make money by selling a stock short, an investor must be able to identify a stock that is both overvalued and likely to experience a correction at some point in the near future. Alternatively, a savvy investor might identify an entire sector that is likely to experience difficulty and short one or several stocks within that sector. In all cases, an investor intent on shorting stocks must pay very careful attention to the amount of money involved in the transaction, as the short sale of stocks, unlike most other investments in the stock market, can generate essentially unlimited losses for an investor.
The short sale of stocks is different from the normal purchase of stocks because it is a bet that a stock will lose value rather than gain value. A typical investor searches for stocks that are undervalued, purchases them, and waits for their value to improve. An investor looking to sell stocks short seeks out stocks that are overvalued and then enters into a contract with a current stockholder, essentially borrowing and then selling their stock. The investor profits if he can replace those borrowed shares at a lower cost than he originally sold them for. If the price of a stock increases after a short sale, then the short seller will lose money, as he will need to pay more money to replace the borrowed stock than he received for selling it.
The nature of the transactions involved in shorting stocks means that the maximum return on investment that an investor could hope to realize is equal to the value of the stock at the time it was sold. This situation would only arise if the value of the stock completely collapsed. An investor can lose an unlimited amount of money on a short sale, however, as the price of a stock could increase by any amount and leave a short seller with an large liability. This characteristic of short selling means that an investor should pay very careful attention to the price of a stock, as the institution from whom the shares have been borrowed is free to demand their return, which requires their repurchase at the current market price.
The key to successfully shorting stocks, then, involves excellent knowledge of a corporation's true value in relation to its market value. An investor must be able to determine that a given company is overvalued by a noticeable amount. If he does so before the market as a whole draws that conclusion, then he can realize a significant profit by shorting that stock.
The identification of bubbles in specific sectors of the economy or in the economies and stock markets of entire nations is also a useful strategy when shorting stocks. During an economic bubble, a whole group of stocks is effectively overvalued. These bubbles sometimes take a long time to burst, but when they do, the results for a careful short seller can be substantial. A clever investor who had shorted Russia's stock market before it collapsed during the Yeltsin era or who sold stocks at the peak of the tech bubble could have made an enormous profit.