Selling Short

Definition:

Short selling or Selling Short is the act of borrowing a security from someone else, usually a broker, selling it and later repurchasing the stock in the hopes that it will be cheaper.

Explanation:

In simple terms opening a short position (or going short, shorting) is used when you think an asset will decrease in price. Short sales require a margin account and have strict margin requirements, so they may not be available to investors with less than $25,000 or so to invest. Part of this is because you are borrowing something that isn’t yours but also because, in theory, the loss can be infinite. When you buy a stock normally, the most you can lose is your purchasing price.

When you are shorting a stock, however, things are a bit more different. If you short a penny stock trading at $0.05, thinking it will go down to $0.01, but instead the company has a breakthrough and the price takes off, your loss can be far more than you were prepared to invest. To close a short, a cover order is used to buy the share you borrowed and essentially give back the share you had borrowed.

Example of Selling Short:

Let’s assume you think stock ABC is going to go from $35 to $30. So you call your broker and decide to short it. You then put money in your margin account which will be added with $35 for the borrowed sale of ABC (or less, sometimes some of the margin is frozen and kept by the broker for trading fees, etc.). You then notice that the price has gone from $35 to $45. The broker than calls you to put more money in your margin account, you decide not to and buy the shares for $45 to give back your borrowed shares. You have then incurred a loss of $10 per share plus the commission fees.

On the other hand, if the price did fall to $30, you could then “cover” your short by buying the shares for cheaper than you sold them, returning the shares to the broker, and keeping the $5 per share difference (minus commissions).