Definition
A short position, also known as “short selling” or “going short,” is an investment strategy where an investor sells a security that they do not own, typically borrowed, in anticipation that the price will decline. The goal is to buy back the security later at a lower price to return to the lender, hopefully pocketing the difference as profit.
Examples
- Stock Market Short Position: An investor forecasts that the price of Company XYZ’s shares will drop. They borrow 100 shares from a broker and sell them at $50 each, bringing in $5,000. If the price drops to $30, the investor can buy 100 shares for $3,000, return them, and realize a $2,000 profit.
- Commodity Market Short Position: A trader believes that the price of crude oil will fall. They take out a short position by borrowing and selling 10 barrels at $100 each, totaling $1,000. If the price drops to $80 per barrel, they can repurchase the 10 barrels for $800, resulting in a $200 profit.
Frequently Asked Questions
What is the risk of a short position?
The risk of a short position is theoretically unlimited because there is no cap on how high a price can rise. Unlike a long position where the maximum loss is the initial investment, price hikes can lead to substantial losses.
How do you “cover” a short position?
To cover a short position, the investor buys back the borrowed securities or assets in the open market and returns them to the lender. Ideally, this is done at a lower price than the initial borrowing cost, securing a profit.
Why would an investor want to enter a short position?
Investors enter short positions primarily to profit from anticipated declines in asset prices. It’s also a way to hedge against other positions or as part of a broader trading strategy.
What are the costs associated with short selling?
Short selling can involve significant costs, including:
- Interest on the borrowed securities: This interest must be paid to the lender.
- Dividends: If the asset pays dividends, the short seller must pay these dividends to the lender.
- Margin requirements: Brokers may require substantial capital reserves to cover potential losses.
Is short selling regulated?
Yes, short selling is subject to regulations to maintain market stability. These include the uptick rule, which restricts short selling in declining stock markets, and various disclosure requirements.
Related Terms with Definitions
- Long Position: An investment where the investor owns the asset and benefits from a price increase.
- Margin: Funds borrowed from a broker to purchase securities, typically used in short selling.
- Hedge Fund: An investment fund that uses various strategies, including short selling, to achieve high returns.
- Borrowing Stock: The act of borrowing shares from a broker for short selling.
- Short Squeeze: A rapid increase in a stock’s price, forcing short sellers to buy back shares to cover their positions, further driving up the price.
Online Resources
Suggested Books for Further Study
- “The Art of Short Selling” by Kathryn F. Staley
- “Short Selling: Strategies, Risks, and Rewards” by Frank J. Fabozzi and Harry M. Markowitz
- “The New Sell and Sell Short” by Alexander Elder
Accounting Basics: “Short Position” Fundamentals Quiz
### What is a short position?
- [ ] Buying securities in anticipation that prices will rise.
- [ ] Holding a stock for a long period.
- [x] Borrowing securities to sell them at a higher price, hoping to buy back at a lower price.
- [ ] Purchasing commodities for future delivery.
> **Explanation:** A short position involves borrowing securities and selling them with the hope of repurchasing them at a lower price to cover the borrowed position and pocket the difference as profit.
### Who typically lends securities for short selling?
- [ ] Investors
- [ ] Investment Banks
- [x] Brokers
- [ ] Hedge Funds
> **Explanation:** Brokers typically lend securities for short selling. They facilitate the borrowing and selling process for investors looking to short sell.
### What term refers to re-buying the shorted securities to return to the lender?
- [ ] Selling
- [ ] Hedging
- [x] Covering
- [ ] Marginalizing
> **Explanation:** Covering refers to buying back the shorted securities to return to the lender, thereby closing out the short position.
### What is a potential consequence of a "short squeeze"?
- [x] An increase in the stock's price due to forced buying.
- [ ] A sustained decrease in the stock’s price.
- [ ] Increased dividends on the stock.
- [ ] Lower trading volume.
> **Explanation:** A short squeeze occurs when there is an increase in the stock's price, forcing short sellers to buy back shares at rising prices, thereby accelerating the price increase.
### What is a primary risk for investors who hold a short position?
- [ ] The risk of dividends decreasing.
- [x] The risk of unlimited losses as prices can rise indefinitely.
- [ ] The interest rate fluctuation.
- [ ] The risk of dilution from stock splits.
> **Explanation:** Investors in a short position face the risk of unlimited losses if the price of the stock they shorted increases indefinitely.
### Which regulation is designed to help limit the potential for abusive short selling?
- [ ] Regulation Best Interest.
- [ ] Regulation T.
- [ ] Regulation SP.
- [x] Regulation SHO.
> **Explanation:** Regulation SHO is designed to oversee and limit abusive short selling practices to maintain market integrity and investor protection.
### What must be maintained in a margin account when engaging in short selling?
- [x] Sufficient equity to cover potential losses.
- [ ] A fixed amount of cash.
- [ ] No additional funds, just the borrowed securities.
- [ ] A percentage of shorted stock's dividends.
> **Explanation:** When engaging in short selling, sufficient equity must be maintained in a margin account to cover potential losses and meet margin requirements set by the broker.
### How does short selling serve as a hedging method?
- [ ] By eliminating taxes on dividends.
- [ ] By capitalizing on dividends paid from short positions.
- [x] By providing a counterbalance to long positions.
- [ ] By reducing transaction costs.
> **Explanation:** Short selling can act as a hedging method by providing a counterbalance to long positions, thereby protecting against market declines.
### Why would an investor need to pay dividends on a borrowed stock used in a short sale?
- [ ] It is a legal requirement for all sold securities.
- [ ] The broker retains the dividends as a fee.
- [x] The investor owes dividends to the lender since they held the stock.
- [ ] The purchaser of the stock claims the dividends.
> **Explanation:** When an investor engages in short selling, they must pay dividends to the lender of the stock as they are technically borrowing the right to the dividends during the time they hold the short position.
### What typically happens to borrowed shares in a short sale after the investor covers their position?
- [ ] They are put back on the market for sale.
- [ ] They are returned to the original lender.
- [ ] They are permanently removed from the market.
- [x] They are returned to the original lender.
> **Explanation:** Borrowed shares in a short sale are typically returned to the original lender after the investor covers their position by buying back the shares.
Continue your educational journey in investing and market strategies by mastering the intricate concepts of short selling and other advanced investment techniques. Happy learning!
