Selling Short

Definition

Selling short, also known as short selling, is an investment strategy where an investor sells securities, commodities, or foreign currency that they do not currently own. The goal of this strategy is to repurchase (or “cover”) the sold items at a lower price, thereby making a profit from the decline in price.

Examples

1. Stock Market: An investor believes that the stock price of ABC Corp., currently at $100, will decline. The investor borrows 100 shares and sells them at $100 each, receiving $10,000. If the stock price drops to $80, the investor buys back the shares for $8,000, returns the borrowed shares, and retains a $2,000 profit (minus any fees or interest).

2. Commodities Market: A trader expects the price of oil, currently at $70 per barrel, to fall. They sell 1,000 barrels of oil that they do not own. If the price falls to $60 per barrel, the trader buys back the oil at the lower price, making a profit of $10,000 (1,000 barrels * $10 price difference).

3. Foreign Exchange Market: An investor anticipates that the value of the British Pound (GBP) will fall relative to the U.S. Dollar (USD). They sell GBP worth $10,000. If the GBP/USD exchange rate falls, the investor can buy back the GBP for fewer dollars, gaining a profit from the difference.

Frequently Asked Questions (FAQs)

Q1. What risks are associated with selling short?

A1: The primary risk is unlimited losses. If the price of the security, commodity, or currency rises instead of falls, the seller must buy it back at a higher price, potentially leading to significant losses.

Q2. How do investors borrow securities for short selling?

A2: Investors typically borrow securities from a brokerage, which holds an inventory of securities for this purpose or borrows them from other investors’ accounts.

Q3. Are there any regulations on short selling?

A3: Yes, short selling is often regulated by financial authorities. For instance, in the U.S., the SEC has specific rules that govern short selling, including the “uptick rule” and reporting requirements for short positions.

Q4. Can short selling be done in retirement accounts?

A4: Generally, short selling is not allowed in retirement accounts like IRAs due to the increased risk and the way these accounts are structured.

Q5. What is a “short squeeze”?

A5: A short squeeze occurs when a stock with significant short interest rises in price, forcing short sellers to cover their positions, thereby driving the price even higher.

Related Terms

1. Short Squeeze: A market condition where a heavily shorted stock’s price rises, forcing short sellers to buy back shares, further driving up the stock price.

2. Margin Call: A broker’s demand for an investor to deposit additional money or securities to cover potential losses.

3. Uptick Rule: A financial regulation that restricts short selling to be at a higher price than the last trade to prevent short sellers from driving the price down rapidly.

4. Leverage: The use of borrowed funds to increase potential returns (and risks) on an investment.

5. Covering a Short: The action of buying back the securities initially sold short to close the short position.

Online References

1. Investopedia on Short Selling
2. U.S. Securities and Exchange Commission (SEC) on Short Sales
3. CFA Institute on Short Selling

Suggested Books for Further Studies

1. “Sell Short: A Simpler, Safer Way to Profit When Stocks Go Down” by Michael Shulman
2. “The Art of Short Selling” by Kathryn F. Staley
3. “Short Selling for the Long Term: How a Combination of Short and Long Positions Leads to Investing Success” by Joseph Parnes
4. “Short Selling Strategies, Risks, and Rewards” by Frank J. Fabozzi

Fundamentals of Selling Short: Investment Strategy Basics Quiz

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