Short Selling

Short Selling, also known as shorting is a financial term referring to the practice of borrowing securities and selling them at current prices with the expectation to repurchase them back at lower prices at some point in the future. The practice of short selling is exactly the opposite of “going long” where investors buy securities with expectation of a price appreciation. When an investor “shorts” a stock for example they anticipate decline in the stock price.

How does Short Selling work?

An investor borrows 1,000 shares of a company A from his broker with the intention to sell them at current market prices. The investor does this because he/she thinks the stock price of company A is overvalued and is due for correction. In most cases the broker who lends the investor the shares, doesn't own the shares, but instead borrows them from another investor who is “long” on this company (expects the stock price to rise in the future). The first investor then sells the shares at market price and he owes the shares back to the broker. At some point in the future the investor needs to return the loaned shares back to the broker, and in order to do that he/she needs to buy them at the market prices at this time. This act of buying back the shares in a short position is called "short covering". At the point of covering the short sale, there are 3 scenarios possible. The first one is when the stock price is the same as at the time of the short sale, and in this case the investor doesn't win or lose anything (not considering any commissions and expenses associated with borrowing the stock). The second scenario is when the stock has fallen in value, since the time of the short sale. In this case the investors buys back the shares sold during the short sale cheaper, and keeps the difference as a profit. The third scenario and the most unpleasant one for the investor is when he/she needs to cover the short position at higher prices that he initially sold. In this case of course the investor must take a loss, buying back the appreciated stock. After the short position has been covered, the investor will have to return the shares to his broker, who in his turn will return them to the investor going "long" on the stock.

There are 2 important things to consider when using short selling. The first one is that the maximum gain of a short sale would be the price at which the investor initially sells the borrowed shares. This is due to the fact that the lowest price a stock can go to is 0, and the potential profit of the short seller is [Initial Sell Price] X [Number of Shares] – [Short Covering Buy Price] X [Number of Shares], which can be maximum of [Initial Sell Price] X [Number of Shares] value. Unfortunately the same is not valid when the short seller needs to cover his position at loss. In this case there is no upper limit of the stock price and the investor faces unlimited losses in theory if the stock goes up (the higher the price goes the bigger the losses). In reality if the price of the company the investor is shorting start to rise, the investor will get a margin call from his broker to deposit more cash in his account or to simply cover the short position at loss.

In conclusion, short selling is an advanced investment technique, which has to be used with caution, because it is associated with significant risks.