Investor Facts: What Is Short Selling?

Short selling a stock is taking an investment position that will rise in value if the targeted stock falls in price.

Short selling is one of the most widely misunderstood investment tactics. Most investors are “long” a stock, meaning that they have bought the stock on the expectation that the price will go up over time.

If the stock does go up in price, the long investor can sell it and realize a profit. The short seller is taking the opposite point of view. He thinks the stock is overpriced and likely to fall in price soon.

The short selling investor does not buy but instead borrows the stock in question. He sells the borrowed shares immediately, collects the cash and waits for the price to fall.

Once the price falls he repurchases the same number shares he previously borrowed more cheaply and returns them to the lender. Since it takes less cash to buy the shares back, the short seller has realized a trading profit.

Stock markets don’t go in just one direction. Over long periods of time, of course, the trend is up. But over the short- and medium-term stocks can fall in value.

A shrewd investor might recognize that the current price of a popular stock has gotten ahead of itself. He believes that the stock is ripe for a sharp decline on any negative news.

That’s when short selling comes into play. The pressure of the stock market is broadly upward, but there are legions of doubters, the short sellers, trying to pull shares in the other direction for their benefit.

That yin and yang of the markets is what makes prices efficient and predictable. Over time, it tends to even out for serious investors.

In the short run, though, some short sellers make out like bandits. And some get hung out to dry.

Cash crunch

The risk for short sellers is when brokerages ask for borrowed shares to be returned. If you sold those shares short, now you have to go buy them again to “cover” the loaned shares.

As a result, “short cover” buying sometimes drives up shares that otherwise have no specific news to drive them higher in price.

The other problem is that short sellers can trade on margin, that is, they use borrowed money to make their trades. That can lead to serious cash crunch if a trade you expect to exit on a decline instead rises.

It has been said that short selling is the ultimate get-rich-quick scheme, a way to become infinitely rich with little risk. The fact is, it’s just as easily a get-poor-quick scheme, a way to become infinitely broke in short order, especially if you use margin loans to trade.

Sophisticated financial advisors managing money for the wealthy or institutions sometimes use short selling to reduce portfolio risk or to set up potential tax advantages.

For most investors, however, short selling is nothing but risk with little reward, and should be avoided.