What it means
In a normal trade, you buy first and sell later and hope the price has gone up. A short position reverses that order.
The investor borrows shares from a broker, sells them immediately at today's price, and later buys the same number of shares in the market to return to the lender. If the price falls in the meantime, the investor buys back at a lower cost and keeps the difference.
If the price rises, the investor has to buy back at a higher cost and takes a loss. While the position is open, the investor usually pays a borrowing fee, must pass on any dividends paid on the shares, and must keep enough collateral in the account to cover possible losses.
The key risk is that losses have no upper limit. A share bought at $50 can fall no lower than zero, so the most a buyer can lose is the amount invested, but a share sold short at $50 can rise to $100 or $200 or higher.
This is why brokers set margin requirements and may close a position if the account runs low. Short selling serves several purposes.
Speculators use it to profit from overvalued companies, and hedgers use it to protect against falls in assets they own, while short sellers also add liquidity and can bring out bad news such as accounting problems earlier. Regulators in some markets restrict it during periods of stress.
The nuance is that the word is also used more broadly. Being short can describe any position that gains when a price falls, such as holding put options or selling futures contracts.
In accounting and cash management, short can also mean having less of something than required, such as a short position in a currency.
In practice
Real-world examples.
Example
A hedge fund analyst finds that a retailer is reporting rising sales but falling cash flow and growing inventory. The fund sells the shares short, expecting the price to fall when the problems become clear.
Example
A fund manager holding a large position in a technology company wants to protect against a market fall. She sells short a related index to offset the risk, so that gains on the short partly cover losses on the holding.
Example
An investor shorts a company after hearing rumours of weak results, but the company announces a takeover and the share price jumps 30%. He must buy back at a heavy loss, because the position was not limited to a set amount.
Formula
Calculation
Profit on a short sale = (sale price - repurchase price) x number of shares - borrowing costs
Suppose an investor sells short 1,000 shares at $50, receiving $50,000. The shares fall and she buys them back at $42, paying $42,000. The trading gain is 50,000 - 42,000 = $8,000. She paid a borrowing fee of 2% a year for three months on $50,000, which is 50,000 x 0.02 x 3 / 12 = $250. The net profit is 8,000 - 250 = $7,750. If the price had instead risen to $60, the loss would be 1,000 x (60 - 50) = $10,000 plus fees.Case study
Seen in the real world.
Falcon Ridge Capital is an illustrative, fictional fund that shorted Pinnacle Gadgets, a fictional company, at $40 a share. The fund's research suggested that the company was overstating its revenue and would be forced to restate its results.
It sold 50,000 shares short, receiving $2,000,000. Three months later the company announced a restatement, the share price fell to $25, and the fund bought back the shares for $1,250,000, earning a gain of $750,000 before costs.
The fund had set a stop-loss, which would have closed the position if the price had risen to $48, limiting the loss to $400,000. The illustrative lesson was that disciplined risk limits matter as much as the analysis, since the potential loss on a short position has no ceiling.
Watch out
Common mistakes.
- Assuming that the loss on a short position is limited to the amount invested, when it is theoretically unlimited.
- Ignoring borrowing fees and dividends owed, which reduce the profit.
- Shorting a stock with very few shares available to trade, which can lead to a squeeze if prices rise.
Questions
People also ask.
Is short selling legal?
In most major markets it is legal and regulated, although some regulators restrict it at times of market stress or require disclosure of large positions.
Why would anyone lend shares to a short seller?
Lenders, such as funds and brokers, earn a fee for lending and keep the economic benefit of owning the shares.
What does it mean to be short a currency?
It means holding a position that gains if the currency falls in value, for example by having sold it forward or borrowed it.
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