Short selling is essentially a buy or sell transaction in reverse. An investor wanting to sell shares borrows them from a broker, who sells the shares from the inventory on behalf of the person seeking to sell short.

Once the shares are sold, the money from the sale is credited to the account of the short seller. In effect, the broker has loaned the shares to the short seller. Eventually, the short sale must be closed by the seller buying an equal amount of shares with which to pay back the loan from their broker. This action is known as covering. The shares the seller buys back are returned to the broker, thus closing the transaction. The ideal situation for the seller occurs if the stock price drops and the shares can be bought back at a lower price than the shorted price.

Key Takeaways

  • In short selling, an investor borrows stock that they think will decline by the upcoming expiration date.
  • The investor then sells the shares that they borrowed to buyers willing to pay the current price.
  • The investor waits for the price of the borrowed shares to drop so that they can buy them back at a lower price, before returning them to the broker.
  • But if the shares don't drop and instead rise, the investor will have to buy them back at a higher price than what they paid, and thus lose money.

The Appeal of Short Selling

Why do people use short selling? Traders may use it as speculation, a risky trading strategy in which there is the potential for both great gains and great losses. Some investors may use it as a hedge against the possibility of losing money on a bet on the same security or a related one. Hedging involves placing an offsetting risk to counter the potential downside effect of a bet on a particular security.

Example of Short Selling

To illustrate the short selling process, consider the following example. A seller goes through a broker and requests to sell 10 shares of a stock currently priced at $10 a share. The broker agrees and the seller is credited with the $100 in proceeds from the sale. Assume that over the short term the stock drops to $5 a share. The seller uses $50 of that $100 to buy 10 shares to repay the broker with and close the transaction.

The seller's remaining profit is $50. Of course, if the shares rise in price, forcing the short seller to purchase them at a higher price than the short sell price, the seller sustains a loss.

Short selling is by nature a very risky proposition with the risk of losing money on a short sale massive—since the price of an asset can surge indefinitely.

The Cost of Waiting

The amount of time a seller can hold onto the short sold shares before buying them back is dependent on the expiration date. However, holding on to shares for long stretches of time while waiting for the security to move higher is not without cost.

The seller must take into account interest charged by the broker on the margin account that is required for short selling. Also, the seller must consider the impact of the money that is tied up in the short sale that is thus not available for other transactions.