Upon making a decision to choose a stock, you are “Taking a Position.” There are two kinds of positions you can choose from. A Long or a Short Position.
Taking a long position means purchasing a stock formulated on the confidence you have in that the price will rise, consequently taking a long, or bullish position. The short position is a bit more complicated. When you short you sell the stocks and then buy them back when the price goes down, earning you a profit.
If you do not own any shares of XYZ stock however you tell your broker to sell short 100 shares of XYZ, you have carried out shorting a stock. In broker’s lingo, you have set up a short position in XYZ of 100 shares. It’s also explained as ‘you hold 100 shares of XYZ short.’
Why would you want to do short selling?
Because you rely on the price of that stock will going down, and so you can then buy it back at a much lower price than you sold it at. The short sale of stock is a gamble that the price of that stock will go down.
Here’s an example:
You determine that XYZ at a price of 110 is at or close to its peak. You think that XYZ will drop in price from this level So you decide to short the stock.
You call your broker and say you want to short 100 shares of XYZ at 110. From your broker you borrow 100 shares of XYZ at 110 and sell it to someone else.
This is the essence of the short sale is that you’re selling something which you borrowed. Again, you borrowed 100 shares of XYZ at 110 and sold it to another party.
In actuality you borrowed the 100 shares of XYZ from your stockbroker. They either have it in inventory or they borrowed it from another client or another brokerage firm. Otherwise, it is your broker that loans you the stock to sell to another party.
So what happens now?
We hope the price of XYZ goes down for you. For instance, say that XYZ declines to 85. At 85, you think that XYZ may not decline much further, if at all.
Now you’d like to take your profits to your portfolio. How do you do that?
You now purchase 100 shares of XYZ at 85 and reimburse your broker the 100 shares of XYZ. You took the stock temporarily at 110 and paid it back at 85. You’ve made 25 per share in profit or 2,500. You sold the borrowed stock for 11,000 and purchased it again for 8,500.
On the other hand, suppose the price of XYZ goes up to 125. You would have sold the stock for 11,000 and now want to retreat from the position. You’ll have to go into the market now and purchase 100 shares of XYZ for 12,500. You would then be returning the loaned stock at 12,500. In this scenario, you’ll have a loss of 1,250.
Some points of common sense
Perhaps a stock you shorted starts to appreciate to a level reaching your account equity. Or when it seems like you will be unable to repurchase the shares in the open market given your current account value; your broker may force the short position to be covered meaning he can call the loan, making you repurchase the stock at a loss in order to deliver the borrowed shares.
Keep in mind that the downside to short selling is theoretically unlimited since a stock might continue to go up. This is different from an average long investment where an equity holder’s downside risk is simply his principal. Shorting a stock is frequently a strong strategy for making big gains or hedging an investment portfolio. Remember the risks for individual investors are very real.
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