Loading the player...

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 the risks.

BREAKING DOWN 'Short Selling'

Consider the following example: A trader believes that stock SS, which is trading at $50, will decline in price. She therefore borrows 100 shares and sells them. The trader is now “short” 100 shares of SS, since she has sold something that she 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.

[Note: Put options provide a great alternative to short-selling by enabling you to profit from a drop in a stock's price without the need for margin or leverage. If you're new to options trading, check out Investopedia's Options for Beginners Course, which provides a comprehensive introduction to the world of options. With over five hours of on-demand video, exercises, and interactive content, you'll learn real strategies to increase consistency of returns and put the odds in your favor.]

Short Sale Metrics

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 could 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.

Short Selling in Context

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 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.

RELATED TERMS
  1. Short Covering

    Short covering is buying back borrowed securities in order to ...
  2. Days To Cover

    Days to cover is a measure of a company's issued shares that ...
  3. Weak Shorts

    Weak shorts refer to traders or investors who hold a short position ...
  4. Short (or Short Position)

    Short or shorting is selling first and buying later, with the ...
  5. Short Squeeze

    A short squeeze is when a heavily shorted security moves sharply ...
  6. Net Short

    Net short is a portfolio or trading position leveraged to an ...
Related Articles
  1. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  2. Investing

    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. Trading

    The Short Squeeze Method

    Trading a short squeeze can be risky, but also very rewarding for those who master it.
  4. Trading

    Short interest: What it tells us

    Whether you agree with the overall sentiment or not, short interest is a data point worth adding to you overall analysis of a stock.
  5. Financial Advisor

    The 5 Most Shorted NYSE Stocks (VALE, CHK)

    Understand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.
  6. Trading

    Understanding Short Covering

    Short covering is buying back borrowed securities to close an open short position.
  7. Investing

    Using Short ETFs to Battle a Down Market

    Instead of selling your stocks to get gains, consider a short selling strategy, specifically one that uses short ETFs that help manage the risk.
  8. Investing

    Rules and Strategies For Profitable Short Selling

    Short sales work well in bull and bear markets but strict entry and risk management rules are required to overcome the threat of short squeezes.
  9. Investing

    Best Performing Short Stocks of 2018 YTD

    Based on short interest, Snap, Tesla, AT&T take the top 3 spots for best returns to short sellers.
RELATED FAQS
  1. What is the difference between a short position and a short sale?

    Learn how short selling and short positioning are different, specifically in regards to the nature of the commodity being ... Read Answer >>
  2. How does one make money short selling?

    Short sellers make money by betting a stock they sell will drop in price. If it drops, the short seller buys it back at a ... Read Answer >>
  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 without technically owning it. Read Answer >>
  4. 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 ... Read Answer >>
Trading Center