Short Selling

What is short selling?

A short sale involves selling a futures contract or other instrument with the idea of delivering on it or offsetting it at a later date. (Source: CFTC)

A short sale is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss.

When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm. The short seller later closes out the position by returning the security to the lender, typically by purchasing securities on the open market. In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to buyer demand, or to hedge the risk of a long position in the same or a related security.

As with buying stock on margin, you are subject to the margin rules. Other fees and charges may apply. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan. (Source: SEC)

In finance, short selling or "shorting" is a way to profit from the decline in price of a security, such as stock or a bond. Most investors "go long" on an investment, hoping that price will rise. To profit from the stock price going down, a short seller can borrow a security and sell it, expecting that it will decrease in value so that they can buy it back at a lower price and keep the difference. For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit. This practice has the potential for an unlimited loss, for example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500.

However, the term "short selling" or "being short" is often used as a blanket term for all those strategies which allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. In fact, what is many times labeled short selling is options or futures activity, since this activity greatly magnifies the gain that results from a securities price loss. For example, if the next earnings release of XYZ company is going to show that its profits declined somewhat in some of its divisions, its stock might decline only 5 percent when that information is released. Someone within the company who wants to trade in inside information however would probably not be satisifed with only a 5 percent gain on his short sell and instead would buy put options or other derivatives or futures to gain possibly 20 or more percent on the decline in the stock price of XYZ. (Source: Wikipedia)