Short Selling

What is a short in finance?

In finance, short selling, shorting or going short is the practice of selling any financial instruments or securities without owning them, and subsequently repurchasing them after their price decline, obtaining profits off the price difference.

What does it mean to be short?

In case of an interim price decline, the short seller will profit, as the (re)purchasing cost is less than the proceeds received upon the initial (short) sale. On the other hand, if the price of a shorted instrument rises prior to repurchase, then the short position closes out as a loss.

In order to short a stock, the trader borrows some of the assets in question from a long-term holder, such as a pension fund, and promises to return them at an agreed time. The trader then sells them on and is now “short”, as they have sold something that they did not own and will – at some point – have to buy it back to return to its owner (covering).

How does somebody make money short selling?

The potential loss on a short sale could be unlimited, as there is no theoretical limit to a rise in the price of the instrument. But in practice the short seller is usually required to post margin or collateral to cover losses. An inability to do so in a timely way would cause its broker or counterparty to liquidate the position. In some cases, the short seller must pay a fee to borrow the securities and must additionally reimburse the lender for cash returns the lender would have received had the securities not been borrowed.

How to measure shorting?

Typically, two metrics are used to track how much a stock has been sold short:

  • Short interest – this refers to the total number of shares sold short as a percentage of the company’s total shares outstanding.
  • Short interest ratio (SIR) – the total number of shares sold short divided by the stock’s average daily trading volume.

Having unlikely high short interest and SIR may be an indicator of a stock at risk of a “short squeeze”, which may lead to an upward price spike. 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.

Is short selling legal?

Short selling has been the subject of controversy, and it is frequently vilified. Some see short sellers as ruthless speculators out to destroy companies.

In reality, short selling adds liquidity to the markets and prevents stocks from being bid up to ridiculously high levels on hype, hence acting as a correcting force of the market. Nevertheless, abusive short-selling practices such as bear raids and rumour-mongering to drive a stock lower are illegal.

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Category: Financial Glossary

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