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What is short selling?


Simple definition of short selling  is the sale of an asset that the seller has borrowed in order to profit later from  fall in the price of the asset. In other words trader sells securities at one price and buys it back at a lower price making gain in the price difference. in this article we are referring to stock although you ca short any instrument or asset, bonds, commodities, currencies, etc. There is usually certain amount of speculation that causes traders to short sell or the need to protect oneself against loss on investment by balancing transaction. Basically there are two basic types of investors, buy-and-hold investors and  day traders. The first hold their portfolio stocks for the long term expecting to see significant rise in price over time which will result in gains. Other category of investors trade on the short term basis. Unlike investors that go long and wait for stock price to build up traders buy stock that will possibly fall in price.

To open short position, seller will have to borrow stock and the lender is usually seller's broker. Short selling is done through margin account which is brokerage account in which broker lends cash to customer to purchase the stock. Loan is collateralized  by purchased securities and includes interest rate while the position is open. Brokers also locate the share for purchase and return them to the end of trade. For instance if a short seller sells 100 borrowed shares worth $20 he is short for that 100 shares. He sold the shares for $2000. But if shares decline in price next week and are now trading at $15 per share short trader will buy 100 shares that he owes to the borrower at this discounted price. In this case he buys back shares for $1500 meaning that he made a profit of $500 minus the interest rate and commission fee.

There are two metrics that help investors to track short selling activities. Short interest ratio (SIR) also known as short float shows how much stock is shorter from company's public float. Other is short interest to volume ratio or "days to cover" ratio. It is calculated when total number of shorted shares are divided by daily average trading volume of the stock. These metrics help feel how other investors feel about particular stocks. If you notice there is high SIR that probably means one of two things; stock is going to decline in price soon or the stock is overvalued. High days to cover is pointing to probable fall in stock price.

Short selling offers opportunity for gains but in the same time it carries unlimited amount of risk. One of such risky situations is short squeeze. It is a situation that happens when stock with high short interest ratio become to quickly rise in price meaning that short sellers are trying to close their position and minimize the loss. This demand for stock only attract more buyers and subsequently pushes the price even further. Short squeeze is a good example of asymmetric risk of short selling. Regular investor can lose 100% of stock that he or she has bought but with traders that borrow stock it is much more risky as they can suffer loss bigger than 100% because potential for stock rise is unlimited. If the price of stock rise instead of decline short seller will have to pay more than what they gained for previously sold borrowed stock in order to close position. Also broker may demand that postion is closed in any time regardless of price. This is one of the reasons why short selling is not recommended to beginner investors but experienced traders familiar with the risks and the ways to avoid them.
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