What Is Short Selling?

Short selling involves selling securities you do not own. Short selling occurs  when an investor sells the shares that he does not own, anticipating that the price will decline in near future at which time he buys back at a lower price and returns to the lender.

When we buy something, we are said to have a long position in that thing. To illustrate, if we buy the stock of XYZ, we pay cash and receive the stock. Some time later, we sell the stock and receive cash. This transaction is lending, in the sense that we pay money today and receive money back in the future.

The rate of return we receive may not be known in advance (if the stock price goes up a lot, we get a high return; if the stock price goes down, we get a negative return), but it is a kind of loan nonetheless.

The opposite of a long position is a short position. A short-sale of XYZ entails borrowing shares of XYZ and then selling them, receiving the cash. Some time later, we buy back the XYZ stock, paying cash for it, and return it to the lender. A short-sale can be viewed as just a way of borrowing money.

There are at least three reasons to short sell:

1. Speculation

A short-sale, considered by itself, makes money if the price of the stock goes down. The idea is to first sell high and then buy low (With a long position, the idea is to first buy low and then sell high).

2. Financing

A short-sale is a way to borrow money, and it is frequently used as a form of financing. This is very common in the bond market.

3. Hedging

You can undertake a short-sale to offset the risk of owning the stock or a derivative on the stock. This is frequently done by market-makers and traders.

How Does Short Selling Work?

Here’s the sequence:

1. Borrowing Shares: Short seller borrows shares from a broker. This is facilitated by other investors holding shares in a margin account.
2. Selling the Borrowed Shares: Short seller sells the borrowed shares in the market at the current price.
3. Buying Back the Shares: Later on short seller buys back the same number of shares, ideally at a lower price.
4. Returning the Shares: Short seller returns the bought back shares to the lender (broker), closes out the position.

Example of Short Selling

Let’s say an investor thinks Company XYZ is overvalued at $100 per share. He borrows 100 shares of Company XYZ from a broker and sells them for $10,000. If the price of Company XYZ goes down to $70 per share, he can buy back the 100 shares for $7,000. Profit before fees and interest would be $3,000.

How Short Selling Works

Short selling has several moving parts:

1. Margin Accounts: To short sell you need to have a margin account with your broker. This allows you to borrow money and securities.
2. Margin Requirements: Brokers require a margin, or collateral, to cover losses. The Federal Reserve’s Regulation T allows brokers to lend up to 50% of the total value of the trade.
3. Interest and Fees: Borrowing shares incurs interest and your broker may charge a fee for facilitating the short sale. These costs can eat into your profits.

Risks of Short Selling

Short selling has big risks that can far outweigh the rewards:

1. Unlimited Losses: Unlike buying stocks where the maximum loss is limited to your initial investment, short selling can result in unlimited losses. If the stock goes up forever the short seller has to buy back the shares at much higher prices.
2. Margin Calls: If the stock price goes up a lot your broker may issue a margin call and require you to deposit more money or securities to cover the increased value of the borrowed shares.
3. Short Squeeze: A short squeeze occurs when a heavily shorted stock’s price starts to go up and short sellers have to buy back shares to cover their positions, which drives the price up even more. This can be very costly.
4. Regulatory Risks: Regulatory bodies can restrict short selling, especially during times of market volatility. They can limit your ability to short or the costs associated with it.

Rewards of Short Selling

Despite the risks short selling has some benefits:

1. Profit from Falling Markets: You can profit from falling asset prices with short selling which you can’t with long positions.
2. Hedging: You can use short selling to hedge against losses in your portfolio. For example short an overvalued stock in a sector and hold a long position in undervalued stocks in the same sector.
3. Market Efficiency: Short selling helps to correct overvalued stocks and ensures prices reflect true value.

Short Selling Strategies

Here are a few strategies that use short selling:

1. Pairs Trading: This involves taking a long position in one stock and a short position in a correlated stock. It’s designed to profit from the relative performance of the two stocks.
2. Arbitrage: Short sellers can exploit price differences between related securities, like convertible bond arbitrage.
3. Sector Rotation: Investors can short sell stocks in sectors that are expected to underperform and go long in sectors that are expected to outperform.

The Bottom Line

Short selling is a complex strategy that can be very profitable but also very risky. If you’re thinking of short selling, you need to understand the mechanics, risks and strategies. By borrowing and selling securities with the intention of buying them back at a lower price you can benefit from market declines, hedge your portfolio and help the market. But be careful, unlimited losses and complexity are involved.

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