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

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).
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).
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.

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.
Margin Call: A broker’s demand for an investor to deposit additional money or securities to cover potential losses.
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.
Leverage: The use of borrowed funds to increase potential returns (and risks) on an investment.
Covering a Short: The action of buying back the securities initially sold short to close the short position.

Online References

Suggested Books for Further Studies

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

Fundamentals of Selling Short: Investment Strategy Basics Quiz

### What does it mean to sell short? - [x] Selling borrowed securities with the intent to repurchase them at a lower price. - [ ] Selling securities you currently own but at a higher price. - [ ] Buying securities with the hope they will appreciate in value. - [ ] Holding securities indefinitely without any intention of selling them. > **Explanation:** Selling short involves selling securities that are borrowed with the intention of repurchasing them at a lower price to turn a profit. ### What is the primary goal of short selling? - [ ] To buy high and sell higher. - [x] To sell high and buy low. - [ ] To buy low and sell high. - [ ] To hold securities for a long term. > **Explanation:** The primary goal of short selling is to sell securities at a high price and then buy them back at a lower price. ### What risk do short sellers face that is unique compared to buying and holding securities? - [ ] Unlimited potential gain. - [ ] Guaranteed small profits. - [x] Unlimited potential loss. - [ ] No financial risk at all. > **Explanation:** Short sellers face the risk of unlimited potential loss because the price of the security can rise indefinitely, increasing the cost to repurchase the security. ### Can short selling be done in all types of brokerage accounts? - [ ] Yes, it can be done in any type of brokerage account. - [ ] No, it is restricted to savings accounts. - [x] No, it cannot typically be done in retirement accounts. - [ ] Yes, but only in non-retirement accounts. > **Explanation:** Generally, short selling is not allowed in retirement accounts such as IRAs. ### What is meant by "covering a short"? - [ ] Initiating a new short position. - [ ] Increasing the amount of shares borrowed. - [x] Buying back the borrowed securities to close the short position. - [ ] Borrowing more shares to sell. > **Explanation:** "Covering a short" means buying back the securities that were initially sold short to close the short position. ### What triggers a margin call in short selling? - [ ] A decrease in the stock price. - [ ] The balance in the investor's account falls below the maintenance margin. - [ ] Increase in dividends of the shorted stock. - [ ] Stock remains unchanged for a long time. > **Explanation:** A margin call occurs when the balance in the investor's account falls below the maintenance margin requirement. ### What is the uptick rule in short selling? - [x] It restricts short selling to be at a higher price than the last trade. - [ ] It allows unlimited short selling. - [ ] It is a requirement to always buy low and sell high. - [ ] It pertains to the timing of when you can cover a short. > **Explanation:** The uptick rule restricts short selling to be at a higher price than the last traded price to prevent a rapid decline in stock prices. ### What often leads to a short squeeze? - [ ] A decrease in dividends. - [ ] Rapid selling off of stocks. - [x] A significant increase in stock price, forcing short sellers to cover their positions. - [ ] No change in the stock price. > **Explanation:** A short squeeze happens when the stock price increases significantly, forcing short sellers to buy back shares to cover their positions, driving the price even higher. ### Short selling generally requires borrowing securities. From whom are these typically borrowed? - [ ] From individual investors directly. - [x] From a brokerage's inventory or other investors' accounts. - [ ] From the national treasury. - [ ] Directly from the companies that issued them. > **Explanation:** Securities for short selling are typically borrowed from a brokerage's inventory or other investors' accounts. ### Which of the following best describes a short seller’s perspective? - [x] Expecting the price of a security to decline. - [ ] Expecting the price of a security to increase. - [ ] Believing the market will remain flat. - [ ] Expecting to receive dividends due to owning the shares. > **Explanation:** A short seller expects the price of a security to decline in order to buy it back at a lower price and make a profit.

Thank you for exploring the intricate world of short selling with us, and taking on our challenging quizzes to deepen your understanding of this investment strategy. Continue building your financial acumen!