Short Selling

In finance, short selling refers to selling something that you do not own. Typically, this refers to stock shares.

The hope is that the price falls and it is possible to buy back whatever you sold at a lower price to make a profit. This is termed 'covering your position'.

In order to sell something short, you must borrow it from someone else, usually a stockbroker. The lender will charge a fee for this service of course. Generally this is in the form of margin interest which the short seller pays continuously to the stockbroker until he has covered his position. This decreases the profit potential of short selling, to a significant degree if the stock is held short for a long time.

It is important to note that buying shares and then selling them (going long) has a very different risk profile from selling short. In the former case, you have limited losses (the price can only go down to zero) but unlimited gains (there is no limit on how high the price can go). When you go short, this is reversed, meaning you have limited possible gains (the stock can only go down to a price of zero), and you can lose more than the original value of the share, with no upper limit. For this reason, short selling is usually used as part of a hedge.

Many short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.

Short selling is sometimes refered to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.

One variant of selling short involves a long position. Selling short against the box refers to holding a long position on which you enter a short sell order. The term box alludes to the days when a safety deposit box was used to store your (long) shares. The purpose of this technique is to lock in paper profits on your long position without having to sell that position. Whether prices increase or decrease, your short position balances your long position and you have locked in your profits (less brokerage fees).

The term "short" is used because the short seller is in a deficit position with their brokerage house. That is, they owe their broker and must repay the shortage when they cover their position. Technically, the broker usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to loan to the short seller.

Short sellers have a negative reputation to some. Businesses hate short sellers who target them, as the short selling drives down the price of their stock and puts the short sellers in a position where they benefit from the business's misfortune, which seems like a ripe opportunity for conspiracies against the business, especially anonymous rumormongering. Others portray short sellers as ghoulish characters that hope for catastrophes. There was a practice in the late 19th century of borrowing people's shares, selling them, then floating horrible rumors in the media about the companies in question, driving the stock price down, then purchasing the shares back at the much lower price. Even today, short sellers have been know to create bear raids by selling blocks of shares that they do not own. To mitigate this problem, most exchanges have instituted an uptick rule. This states that a short seller cannot cover his/her position unless the last market price of the stock was up from the previous price.

Advocates of short sellers have stated that their scrutiny of companies' finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies' stock long. Some hedge funds and short sellers claimed that the accounting of Enron and Tyco was suspicious, months before their respective financial scandals manifested.

Short sellers must be aware of the potential for a short squeeze. This is a sharp uptick in the price of a stock, caused by large numbers of short sellers covering their positions on that stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. (This may occur in an automated way if the short sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering.

Short sellers must also be aware of the potential for liquidity squeezes. This occurs when a lack of potential (long) buyers, or an excess of coverers, makes it difficult to cover your position. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments.