What is a 'Short (or Short Position)'
A short, or short position, is a directional trading or investment strategy where the investor sells shares of borrowed stock in the open market. The expectation of the investor is that the price of the stock will decrease over time, at which point the he will purchase the shares in the open market and return the shares to the broker which he borrowed them from.
BREAKING DOWN 'Short (or Short Position)'While getting into a short position is usually done with stocks, the same logic of the trade applies to other types of assets such as stock options, exchange-traded funds (ETFs), commodities and currencies. Short-selling puts the investor into a position of unlimited risk and a capped reward. For example, if an investor enters into a short position on a stock trading at $20, the most he can gain is $20 less fees, while the most he can lose is infinite since the stock can technically increase in price forever. Short-selling is one strategy to use if you believe the price of the underlying asset will decrease in the future and you want to profit from that loss.
Short Position Mechanics and Example
To go short a stock, an investor must borrow the shares from their brokerage firm, agreeing to pay an interest rate as a fee. Once the shares are secured and borrowed, the investor sells them on the open market at the current price and receives the cash for the trade. At this point, a negative position amount is recorded in the investors account. Later, if the price declines, the investor buys the same amount of shares in the open market and returns them to the broker. If the shares have declined, the investor makes a profit. If the shares increased in price over the time period, the investor takes a loss and owes that money to the brokerage firm.
For example, assume that Company XYZ is trading at $100 per share and an investor believes the price will decline over the next six months. He decides to short-sell 100 shares of Company XYZ. The transaction is initiated and the investor sees $10,000 cash posted in his account, as well as a negative $10,000 position in Company XYZ. Very often, if not all the time, this cash is not accessible and remains frozen in the account. To borrow the shares for six months, the investor agrees to pay 8% interest.
Six months later the shares are priced at $75 per share. The account now looks as follows:
Short sale proceeds = $10,000
Short position in Company XYZ = $7,500
Margin interest due = $800
At this point, the investor purchases 100 shares at market price and returns them to the broker. His profit is:
Profit = $10,000 - $7,500 - $800 = $1,700
Learn more about this dynamic strategy by reading When To Short A Stock.