Short Selling

AAA

DEFINITION of 'Short Selling'

The sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders who are familiar with its risks.

INVESTOPEDIA EXPLAINS 'Short Selling'

Consider the following short-selling example. A trader believes that stock SS which is trading at $50 will decline in price, and therefore borrows 100 shares and sells them. The trader is now “short” 100 shares of SS since he has sold something that he did not own in the first place. The short sale was only made possible by borrowing the shares, which the owner may demand back at some point.

A week later, SS reports dismal financial results for the quarter, and the stock falls to $45. The trader decides to close the short position, and buys 100 shares of SS at $45 on the open market to replace the borrowed shares. The trader’s profit on the short sale – excluding commissions and interest on the margin account – is therefore $500.

Suppose the trader did not close out the short position at $45 but decided to leave it open to capitalize on a further price decline. Now, assume that a rival company swoops in to acquire SS because of its lower valuation, and announces a takeover offer for SS at $65 per share. If the trader decides to close the short position at $65, the loss on the short sale would amount to $15 per share or $1,500, since the shares were bought back at a significantly higher price.

Two metrics used to track how heavily a stock has been sold short are short interest and short interest ratio (SIR). Short interest refers to the total number of shares sold short as a percentage of the company’s total shares outstanding, while SIR is the total number of shares sold short divided by the stock’s average daily trading volume.

A stock that has unusually high short interest and SIR may be at risk of a “short squeeze,” which may lead to an upward price spike. This is a constant risk that the short seller has to face. Apart from this risk of runaway losses, the short seller is also on the hook for dividends that may be paid by the shorted stock. In addition, for heavily shorted stocks there is a risk of a “buy in.” This refers to the fact that a brokerage can close out a short position at any time if the stock is exceedingly hard to borrow and the stock's lenders are demanding it back.

While short selling is frequently vilified and short sellers viewed as ruthless operators out to destroy companies, the reality is that short selling provides liquidity to the markets and prevents stocks from being bid up to ridiculously high levels on hype and over-optimism. Although abusive short-selling practices such as bear raids and rumor-mongering to drive a stock lower are illegal, short selling when done properly can be a good tool for portfolio risk management.

Deepen your knowledge of short selling by reading the basic guide on Short Selling: Introduction.

VIDEO

Loading the player...
RELATED TERMS
  1. Bear Raid

    The illegal practice of ganging up to push a stock's price lower ...
  2. Short Squeeze

    A situation in which a heavily shorted stock or commodity moves ...
  3. Short (or Short Position)

    1. The sale of a borrowed security, commodity or currency with ...
  4. Short Sell Against the Box

    The act of short selling securities that you already own. This ...
  5. Short Interest

    The quantity of stock shares that investors have sold short but ...
  6. Buy To Cover

    A buy order made on a stock or other listed security that closes ...
RELATED FAQS
  1. How can I profit from a fall in stock prices of companies in the financial services ...

    The financial services sector, made up of investment brokerage houses, credit services companies and asset management firms, ... Read Full Answer >>
  2. How does short selling help the market and investors?

    Most investment analysts agree that short selling is ethical. Despite the belief that the practice represents profiting off ... Read Full Answer >>
  3. Is short selling ethical?

    Although it suffers from a bad reputation with the general public, there is nothing inherently unethical about the practice ... Read Full Answer >>
  4. How is it possible to trade on a stock you don't own, as is done in short selling?

    Short selling is essentially a buy/sell transaction in reverse. The stock shares that the seller wishes to sell are borrowed ... Read Full Answer >>
  5. When short selling, how long should you hold on to a short?

    An investor should hold a short sell position for as long as the investment is profitable and as long as the investor can ... Read Full Answer >>
  6. What's the difference between a long and short position in the market?

    Essentially, when speaking of stocks, long positions are those that are owned and short positions are those that are owed. ... Read Full Answer >>
  7. What is the difference between shorting and naked shorting?

    Short selling involves borrowing shares of a company’s stock and selling it with the hope it can be bought back at a later ... Read Full Answer >>
Related Articles
  1. Active Trading Fundamentals

    When To Short A Stock

    Learn how to make money off failing shares.
  2. Active Trading Fundamentals

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  3. Active Trading Fundamentals

    Finding Short Candidates With Technical Analysis

    Learn how to distinguish tops and bottoms in the equity market when short selling.
  4. Options & Futures

    Questioning The Virtue Of A Short Sale

    This controversial strategy is blamed for making and breaking markets. Read on to learn more.
  5. Active Trading Fundamentals

    Short Selling Tutorial

    Want to profit on declining stocks? This trading strategy does just that.
  6. Mutual Funds & ETFs

    How To Choose The Right ETF?

    Choosing the right ETF really isn’t that complicated. If you stay focused on a few key areas, you may find the experience to be much easier.
  7. Investing Basics

    Explaining Market Value of Equity

    Market value of equity is the total value of all the outstanding stock as measured in the stock market at a particular time.
  8. Investing

    Cloud Investments: Profitable If Chosen Carefully

    By owning stock in cloud-based service companies, you can follow the latest trends and make money from the explosive growth in the cloud industry.
  9. Investing

    What Tech Companies Seeking Funding Must Overcome

    Tech companies face a unique set of challenges, including a need for timely responses to changes in technology and difficulty recruiting the right talent.
  10. Economics

    Vietnam -- New Asian Hot Spot For Tech Investment

    Vietnam now has a rapidly expanding tech sector that's attracting investors from around the globe due to low business costs and highly skilled workers.

You May Also Like

Hot Definitions
  1. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  2. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  3. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  4. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  5. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  6. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
Trading Center