Business, Legal & Accounting Glossary
In finance, short selling is selling something that one does not (yet) own.
Typically, this refers to stock shares. In a sense, short selling stocks means to own a negative amount of stocks.
The hope is that the price falls and it is possible to buy whatever was sold at a lower price, deliver it to the buyer at the previous higher price and make a profit. This is termed ‘covering your position’.
In order to sell stocks short, one must borrow it from someone else, usually a stockbroker. The lender will charge a fee for this service of course. Generally, this is in the form of “margin interest” which the short seller pays continuously to the stockbroker until he has covered his position. This decreases the profit potential of short selling, especially if the stock is held short for a long time.
When dealing with futures contracts, being “short” means having the obligation to deliver (or buy back) something that was already sold. This is often an instrument used by producers or farmers to fix the price of goods they have yet to mine or grow.
It is possible that the term “short” derives from the name of a notorious stockbroker of the 1920s that used the practice to defraud his customers. It is more commonly understood that the term “short” is used because the short seller is in a deficit position with his brokerage house. That is, he owes his broker and must repay the shortage when he covers his position. Technically, the broker usually, in turn, has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to loan to the short seller.
It is important to note that buying shares and then selling them (called “going long”) has a very different risk profile from selling short. In the former case, losses are limited (the price can only go down to zero) but gains are unlimited (there is no limit on how high the price can go). In short selling, this is reversed, meaning the possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, with no upper limit. For this reason, short selling is usually used as part of a hedge.
Many short sellers place a “stop-loss order” with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock’s price skyrockets, the stockbroker may decide to cover the short seller’s position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.
Short sellers must be aware of the potential for a short squeeze. This is a sharp uptick in the price of a stock, caused by large numbers of short-sellers covering their positions on that stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. (This may occur in an automated way if the short-sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an even further rise in the stock’s price, which in turn may trigger additional covering.
On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices many short positions, and buys many shares, with the intent of selling them to the short-sellers who will be panicked by the initial uptick.
Short sellers who are borrowing money from their brokerage house also must be aware of the margin call, a demand for additional funds from their broker, because of, in the case of shorting, a rise in the price of the security being shorted.
Short sellers must also be aware of the potential for liquidity squeezes. This occurs when a lack of potential (long) buyers, or an excess of coverers, makes it difficult to cover the short-sellers’ position. Because of this, most short-sellers restrict their activities to heavily traded stocks, and they keep an eye on the “short interest” levels of their short investments. Short interest is defined as the total number of shares that have been sold short, but not yet covered.
One variant of selling short involves a long position. “Selling short against the box” is holding a long position on which one enters a short sell order. The term box alludes to the days when a safe deposit box was used to store (long) shares. The purpose of this technique is to lock in paper profits on the long position without having to sell that position. Whether prices increase or decrease, the short position balances the long position and the profits are locked in (less brokerage fees).
Short sellers have a negative reputation to some. Businesses hate short-sellers who target them, as the short-selling drives down the price of their stock and puts the short-sellers in a position where they benefit from the business’s misfortune, which seems like a ripe opportunity for conspiracies against the business, especially anonymous rumours. Others portray short-sellers as ghoulish characters who hope for catastrophes. There was a practice in the late 19th century of borrowing people’s shares, selling them, then floating horrible rumours in the media about the companies in question, driving the stock price down, then purchasing the shares back at the much lower price. Even today, short-sellers have been known to create bear raids by selling blocks of shares that they do not own. To mitigate this problem, the SEC (Securities and Exchange Commission) has instituted an uptick rule. This states that a short seller cannot cover his/her position unless the last market price of the stock was up from the previous price.
Advocates of short-sellers have stated that their scrutiny of companies’ finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies’ stock long. Some hedge funds and short-sellers claimed that the accounting of Enron and Tyco was suspicious, months before their respective financial scandals manifested.
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This glossary post was last updated: 13th February, 2020