What it means
Most people think of investing as buying low and selling high. Short selling reverses the order, so you sell high first and buy low later.
The investor borrows shares from a broker, sells them at the current price, and later purchases the same number of shares to return them. The attraction is that an investor can profit from a falling price, or protect a portfolio against a fall.
Funds use shorts to hedge, meaning to reduce risk by holding offsetting positions. A fund that holds shares in one airline might short another airline to limit the damage from a fall in the whole sector.
The risks are different from buying shares. A buyer can lose only the amount invested, but a short seller's loss grows without limit as the price rises.
A short seller must also pay a fee to borrow the shares and any dividends paid while the position is open. If the price climbs quickly, the broker may issue a margin call, which is a demand for extra cash to cover the loss.
A rush by many short sellers to buy back shares at once can push the price even higher, which is called a short squeeze. For these reasons, short selling is mainly used by experienced investors with strict risk limits.
The word short also appears in other settings, such as being short of cash or short of stock. In currency and commodity markets it can mean having sold more than you own or expect to receive.
The context tells you which meaning applies. Rules on short selling vary by country and may restrict it during market stress.
Regulators often require disclosure of large short positions. Anyone considering it should check the rules that apply to their broker and market.
In practice
Real-world examples.
Example
A hedge fund believes a retailer is overvalued and shorts its shares. When the retailer reports weak sales, the price drops and the fund buys back its position for a profit. The fund records the gain and the borrowing fee, and reports the net result to its investors at the end of the quarter.
Example
A pension fund holds a large stake in a bank and shorts a banking index to protect against a downturn. If banking shares fall, the gain on the short offsets part of the loss on the stake. The fund gives up some upside if banks rise, which is the price of the protection.
Example
A trader shorts a technology company and the shares rise 40% after a surprise takeover bid. The broker issues a margin call, and the trader has to close the position at a large loss. The episode shows how quickly a short can move against its owner.
Formula
Calculation
Profit on a short = (sale price - buy-back price) x number of shares - borrowing costs
Suppose an investor shorts 1,000 shares at $50, raising 1,000 x 50 = $50,000. Three months later the price has fallen to $42 and she buys the shares back for 1,000 x 42 = $42,000. The gross gain is 50,000 - 42,000 = $8,000. The borrowing fee at 3% a year for three months is 50,000 x 0.03 x 3/12 = $375, so the net gain is 8,000 - 375 = $7,625.Case study
Seen in the real world.
Quillfeather Capital is an illustrative, fictional fund that shorted the shares of a company it believed was overstating its revenue. It sold 20,000 shares at $30 for $600,000 and expected the price to fall once the accounts were corrected.
Instead, a rival unexpectedly announced a bid and the price jumped to $45. The fund faced a paper loss of 20,000 x (45 - 30) = $300,000 and a margin call for more cash.
The risk manager closed half the position to limit the damage. The illustrative lesson is that a short can be right in the long run and still cause severe losses along the way. The fund now sets a maximum loss on every short before it opens the position and sticks to it.
Watch out
Common mistakes.
- Believing the maximum loss on a short is the amount invested, when there is no upper limit on how high a price can go.
- Ignoring borrowing fees and dividends owed, which reduce the profit on a position held for months.
- Shorting a stock that is hard to borrow or heavily shorted already, which raises the risk of a squeeze.
Questions
People also ask.
What is a short squeeze?
A short squeeze is a sharp price rise caused by short sellers buying back shares to cut their losses, which pushes the price up further.
Do I own the shares I short?
No, you borrow them, which is why you must return the same number of shares later and pay any fees.
Is shorting legal?
In most major markets it is legal but regulated, and the rules can tighten during periods of market stress.
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