What is 'Short Selling'
Short selling is 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.
BREAKING DOWN '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.