What is Short Selling?

Short Selling Stock (or going short a stock) is the process of borrowing shares from a 3rd party (typically a broker) and immediately selling the shares with the promise to buy back the stock at a later date.  The main intention (or hope) for the short seller is that the stock will decrease in value.   The inherent danger in short-selling is the potential for the security to increase in price above what the initial short (sale) price is.  Any price increase over the initial short sale price will be a loss to the party with the short, since they will be responsible for buying back shares at a higher price.

Let’s try to explain this with a couple of examples (one with a profit and one with a loss):

Example 1: XYZ stock has deteriorating fundamentals and you believe the stock will decrease in value.  XYZ  stock is currently trading at $100 per share.  You decide to short 100 shares of XYZ @$100 per share.  In order for this transaction to take place, you borrow the 100 shares from your brokerage.  The transaction looks like this.

  • Borrow 100 Shares and Sell Short @ $100 per share.  Proceeds from Sale = $10000
  • Shares of XYZ rise to $120 per share.   The stock is obviously moving in the wrong direction, and you decide to close out your short.  In order cover your short position, you will need to purchase XYZ shares in the open market.
  • Your loss on the transaction is $120-$100 * 100 shares = $2000.

Example 2: Again, XYZ stock has deteriorating fundamentals and you believe the stock will decrease in value.  XYZ  stock is currently trading at $100 per share.  You decide to short 100 shares of XYZ @$100 per share.  In order for this transaction to take place, you borrow the 100 shares from your brokerage.  The transaction looks like this.

  • Borrow 100 Shares and Sell Short @ $100 per share.  Proceeds from Sale = $10000
  • Shares of XYZ fall to $80 per share.   The stock is obviously moving in the RIGHT direction, and you decide to close out your short.  In order cover your short position, you will need to purchase XYZ shares in the open market.
  • Your GAIN on the transaction is $100-80 * 100 shares = $2000.

These are simple examples and there are a few things i omitted.   Namely, that in order to short a stock, you must have a margin account enabled with your brokerage.  According to Regulation T, the initial margin requirement on a short sale calls for “150% of the short sale proceeds.”  This means that the entire amount received from the proceeds of the sale plus an additional 50% of the proceeds is the initial margin requirement on a short position.

Also, not every stock can be shorted.  If a stock is in short supply (also known as “hard to borrow”), there may not be shares available for you to borrow.  This often happens if a stock has a small float, and a very high short interest.

And when a stock has a high short interest, there is also the possibility for a “short-squeeze“, which can be dangerous when shorting a stock.

Plus it should be noted, that if the stock you short pays a dividend, you are responsible for the payment of this dividend, which can ultimately limit your profits on the short sale.