What is "Short Selling" or "Shorting a Stock"?

There are a few variations of terms associated with this concept so first let me throw out the common  phrases and then explain what it actually is…

"Short a stock" (Short is used as a verb)

"Short position" (Short used an an adjective)

"Short Selling" (Short used as an adjective)

…are the three most common uses of the term "short" as it relates to investing.  Okay great, but what the heck does it mean?!

QuestionMark.jpgShorting a stock means selling shares of a stock THAT YOU DO NOT OWN. You would only do this if you expected that stock TO DECREASE IN VALUE. Eventually you have to "cover your short position" by buying the stock later (hopefully at a lower price than what you sold it for). This is a backwards way of buying low and selling high in that you actually start out by selling high and then buying low. Confused yet? :) Keep reading…

Let’s use an example: Let’s say that company ABC’s shares are trading at $50.00 per share today.  You believe that this company is going down the tubes. You decide to short-sell 100 shares of the stock at the market price of $50.00.  This means that you have collected $50.00 x 100 shares = $5,000. The next day, ABC declines to $40.00.  You decide to "cover your short position" by BUYING 100 shares of ABC for $4,000 (100 shares x $40.00).  You have made a $1,000 profit since you correctly determined that the company would decline in value.

Okay, so now you are wondering how you can sell shares of a company that you do not own, right? Well, it’s a bit technical to explain but try this explanation on for size: you actually BORROW the shares from another investor and pay him interest while you have the short position open. Of course it would be hard to just find someone willing to lend you the use of their shares so this is handled by your broker and it is all done electronically – so all you have to do is tell your broker that you want to short a stock and they will find the shares (usually from their own inventory) and they will also handle charging the interest to your account.

Also, it should be pointed out what happens if the stock you short GOES UP in value instead of decreasing like you hope it will.  Let’s take the same $50.00 per share price of ABC’s stock.  Again you sell the shares and receive $5,000 for it, but now the stock rises to $60 per share and everyone thinks that it is only going to go up even further now after a news release that says the companies’ sales are increasing faster than ever (or some other such good news).  You decide to cut your losses and cover your short position by buying shares at $60.00 per share ( x 100 shares) for $6,000.  The net effect is that you have bought the shares for $6,000 and sold them for $5,000, therefore you have a $1,000 LOSS.

Note that when you buy a stock with the expectation of selling it later at a profit (the way you are used to doing it) is called being "LONG A STOCK" or a "LONG POSITION". 

If you found this article of interest, please consider subscribing to my RSS Feed. If you want to learn more about what an RSS Feed is, click here. Thanks!

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
Related Posts