What is a Short (or Short Position)
A short, or short position, is selling first and then buying later. The trader's expectation is that the price will drop; the price they sell at is higher than the price they buy it at later. The difference between the sale price and the buy price produces a profit or loss. In the forex and futures markets, a short position can be initiated at any time. In the stock market, the trader must borrow shares from a broker in order to short them. This creates a share deficient in the account. When the trader buys the shares back, the borrowed shares are returned to the broker and the profit or loss on the trade is realized.
Breaking Down Short (or Short Position)
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 they can gain is $20 per share (stock to goes to $0), while the most they can lose is infinite since the stock can theoretically increase in price forever. That said, a short position can be closed at any time. Therefore, traders can manage risk on short positions the same as they would when buying a stock.
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 decline.
Short Position Mechanics and Example
To short a stock, an investor borrows the shares from their brokerage firm. 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 investor's 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 trader believes the price will decline over the next six months. They short-sell 100 shares of Company XYZ. The transaction is initiated and the trader sees $10,000 cash posted in their account, as well as a negative $10,000 position in Company XYZ. Since the cash received is part of an open trade, it cannot be withdrawn and typically it cannot be used. To borrow the shares for six months, the short-seller agrees to pay 4% interest (yearly).
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 = $200 [(4% / 12) x 6 months x $10,000]
At this point, the trader purchases 100 shares at market price and returns them to the broker. The trade is complete.
Their profit is $10,000 - $7,500 - $200 = $2,300
If the price went up, the trader would owe money as well as interest. If the price increased to $110, the trader would need to pay $11,000 ($110 x 100 shares) to buy the shares back, which means they are losing $1,000.
If a short position is losing money, the trader may be asked/required to put up more capital to cover the loss. In other words, the loss is not allowed to mount indefinitely. Being asked to put up more capital to cover the losses on a position is a margin call.