What is a short sale?

Today, people generally think of a “short sale” as a real estate transaction in which the home owner sells his property for less than the mortgage.   Before the housing crisis, “short sale” referred to a transaction in the stock market. So what does it mean when we sell a stock “short.”

Borrowing a security from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker.

Short selling (or “selling short”) is a technique used by investors who try to profit from the falling price of a stock. For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall. The investor’s broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price. If the price of the shares drops, he/she “covers the short position” by buying back the shares, and his/her broker returns them to the lender. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock.

But if the price of the shares increase, the potential losses are unlimited. The company’s shares may go up and up, but at some point the investor has to replace the 100 shares he/she sold. In that case, the losses can mount without limit until the short position is covered. For this reason, short selling is a very risky technique.

Tagged
%d bloggers like this: