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

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. Naked Shorting

    The illegal practice of short selling shares that have not been ...
  4. Short (or Short Position)

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

    The act of short selling securities that you already own. This ...
  6. Buy To Cover

    A buy order made on a stock or other listed security that closes ...
RELATED FAQS
  1. How does short selling help the market and investors?

    Find out how short sellers provide a service to the market by acting as a check against overvalued companies and exposing ...
  2. Is short selling ethical?

    Understand the concept and practice of short selling, and examine the ethical questions that some investors raise in regard ...
  3. How is it possible to trade on a stock you don't own, as is done in short selling?

    Understand how the process of short selling allows a person to sell a stock he or she doesn't technically own by borrowing ...
  4. When short selling, how long should you hold on to a short?

    Explore the reasons for short selling and the various factors that influence how long an investor may wish to maintain a ...
  5. What's the difference between a long and short position in the market?

    Understand long and short positions for stocks and option contracts; combine long and short positions for added leverage ...
  6. What is the difference between shorting and naked shorting?

    Short selling involves borrowing shares of a company’s stock and selling it with the hopes it can be bought back at ...
Related Articles
  1. Active Trading Fundamentals

    When To Short A Stock

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

    Finding Short Candidates With Technical Analysis

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

    Questioning The Virtue Of A Short Sale

    This controversial strategy is blamed for making and breaking markets. Read on to learn more.
  4. 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.
  5. Active Trading Fundamentals

    Short Selling Tutorial

    Want to profit on declining stocks? This trading strategy does just that.
  6. Trading Strategies

    How Social Impact Investing Works

    Social impact investing is changing the way investors and the government effect change, delivering quantifiable results and financial returns.
  7. Investing

    Are These 2015's Most-Promising Small-Cap Stocks?

    At least one of these small-caps should spike in 2015.
  8. Investing

    Is the Best Plan for Pot Investing 'Wait-and-see?'

    Legalized marijuana is an emerging industry and those interested in investing in it should proceed with caution.
  9. Mutual Funds & ETFs

    Are These the Top Inverse ETFs of 2015?

    Short shy? Here's a list of top inverse ETFs to help you profit from a decline in the value of an index or group of stocks.
  10. Investing Basics

    Are You Investing With A Purpose?

    We all appreciate having a wide variety of investing choices, but a random collection of investments does not make an investing plan.

You May Also Like

Hot Definitions
  1. Technical Skills

    1. The knowledge and abilities needed to accomplish mathematical, engineering, scientific or computer-related duties, as ...
  2. Prepaid Expense

    A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received ...
  3. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
  4. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
  5. Law Of Supply

    A microeconomic law stating that, all other factors being equal, as the price of a good or service increases, the quantity ...
  6. Investment Grade

    A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such ...
Trading Center