Short selling is an investment or trading strategy that speculates on the decline in a stock or different securities price. It is an advanced strategy that should solely be undertaken by experienced traders and investors.

Traders might also use short selling as speculation, and investors or portfolio managers might also use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation includes the possibility of large risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to limit risk exposure.

In short selling, a position is opened by borrowing shares of a stock or different asset that the investor believes will decrease in value by a set future date—the expiration date. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will proceed to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically limitless considering the price of any asset can climb to infinity.

Key Takeaways

• Short selling takes place when an investor borrows a security and sells it on the open market, planning to buy it again later for much less money.
• Short sellers wager on, and profit from, a drop in a security’s price.
• Short selling has a high risk/reward ratio: It can provide big profits, however losses can mount rapidly and infinitely.

Understanding Short Selling

Wimpy of the famous Popeye comic strip would have been a perfect short seller. The comedian character used to be well-known for announcing he would “gladly pay subsequent Tuesday for a hamburger today.” In short selling, the seller opens a position by means of borrowing shares, typically from a broker-dealer. The short seller will try to make money on the use of those shares before they must return them to the lender.

To open a short position, a trader need to have a margin account and will normally have to pay interest on the value of the borrowed shares whilst the position is open. Also, the Financial Industry Regulatory Authority, Inc. (FINRA), which enforces the regulations and policies governing registered brokers and broker-dealer companies in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the quantity that the margin account need to maintain—known as the maintenance margin. If an investor’s account cost falls beneath the upkeep margin, more funds are required, or the position may be sold with the aid of the broker.

To close a brief position, a trader buys the shares returned on the market—hopefully at a price much less than what they borrowed the asset—and returns them to the lender or broker. Traders need to account for any pastime charged with the aid of the dealer or commissions charged on trades.

The procedure of finding shares that can be borrowed and returning them at the end of the trade are handled behind the scenes via the broker. Opening and closing the trade can be made via the regular trading platforms with most brokers. However, each broker will have qualifications the trading account must meet earlier than they allow margin trading.

As noted earlier, one of the primary reasons to engage in short selling is to speculate. Conventional lengthy strategies (stocks are bought) can be labeled as investment or speculation, depending on two parameters—(a) the degree of risk undertaken in the trade, and (b) the time horizon of the trade. Investing tends to be lower risk and generally has a long-term time horizon that spans years or decades. Speculation is a notably higher-risk recreation and generally has a short-term time horizon.