What is ‘Short Selling’?

You may be surprised how little you know about short selling. It is a simple concept but is a bit difficult to explain on paper. If you have been following the current economic crisis you would know that short selling was banned in close to 800 companies on the New York Stock Exchange. So, let’s find out what short selling is.

So Why Short Sell Stocks? Speculation

The most apparent reason to short sell is to profit from what the investor believes is an overpriced stock or market. The investor is betting on the fact that a possible “bubble” will burst, and can earn money on losing stocks.

Basic Overview

Let’s put this in easy terms. When an investor goes “long”, it simply means that they have bought into a stock believing that the value of the stock will increase. When an investor goes “short”, they anticipate a decrease in share price.

Now, “short selling” is the selling of a stock that the actual seller doesn’t own, and more specifically, a short sale is the sale of a security that isn’t owned by the seller, but that is actually promised to be delivered. Now you must be confused on that last sentence. But bear with me.

Let’s say you want to short sell a stock. Your broker will lend it to you. the stock will come from your brokerage’s own inventory, from another one of their own customers, or even in some cases from another brokerage firm. Is this even legal? Well look at a bank. When a person goes into a bank for a loan, you are receiving money up front, sometimes the money from other customers. It isn’t as simple as that but when you deposit money into the bank, even though you are entitled to it, the bank can turn around and do whatever they please with your money. They can lend it to someone else or they can invest it, or purchase assets. Everything is fine as long as everyone doesn’t come to the bank at the same time demanding their money. This is the same with a stock broker. They hold onto all these stocks from all these investors.

So when an investor short sells, they are borrowing the stock from their broker who is entitled to lend it out, which comes from some other client. The shares are sold and the proceeds are credited to your account. But here is the deal. Sooner or later you, as an investor, must “close” the short by buying back the same number of shares, also called “covering”. Once this is done it is returned to the broker. So if the price of the stock drops, you can buy back that stock at a lower price and make a profit. In contrast, if the price of the stock rises, you have to buy it back at the higher price and you lose money. So short selling is simply an investor trying to make money from a stock losing value and not gaining it.

There are many regulations involved in short selling. For instance, in a lot of cases an investor can hold a short for as long as they want, but if the broker who lent it to you demands it back you will be forced to cover it. This can be very risky and takes a lot of trust in who you choose for a lender. Brokers can’t sell what they don’t have. Sometimes you can purchase those shares they need and keep the short or you will have to cover. This term is actually noted as “called away”.

Since the investor doesn’t actually own the stock, the same one that was borrowed and sold, they must pay the lender any dividends or rights declared during the course of the loan. If the stock splits during the course of the short, the investor will owe twice the number of shares at half the price. And because the investor is being loaned the stock, they are buying on margin, therefore they have to open a margin account to short stocks.