short selling

DEFINITION: The phrase “short selling” refers to the investment or trading practice of profiting from the anticipated decrease in the price of a stock or other type of security.

Short selling involves initiating a position by borrowing shares from a bank or other lending institution and selling them immediately on the open market, with the contractual obligation of returning the shares to the bank (and thus of buying them back) by a specified due date.

In essence, the short seller is betting that the shares he sold (and owes to the bank) will decline in value during the intervening time period.

If they do, then the short seller will pay a smaller amount to buy the shares back than he received when he sold them. This means he will be able to pocket the difference between the two prices (less the bank’s lending fee).

However, if the short seller bets wrong, and the shares increase in value, then the short seller—who is still under contractual obligation to return the shares to bank by the due date—must buy them back anyway at the higher price.

Since he has to pay out more money now than he received when he sold the shares earlier (because their price is now higher), he loses money on the deal.

It is important to note that short selling is highly risky because the possibility of loss is theoretically boundless (seeing that, theoretically, the price of the shares could rise practically without limit).

For this reason, short selling is a sophisticated strategy best suited for adept traders and seasoned investors.

ETYMOLOGY: The origin of short selling has been traced to the Dutch businessman, Isaac Le Maire, a major shareholder of the Dutch East India Company, in 1609.

The English adjective “short” derives, via Middle English, from Old English scort.

The English gerund “selling,” from the verb “to sell,” derives from Middle English sellen and Old English sellan, which is akin to Old High German sellen, meaning “to sell,” and Old Norse sala, meaning “sale.”

USAGE: Short selling may serve as a speculative tool for traders, while investors or portfolio managers might employ it as a safeguard against potential losses when taking a long position in the same or a related security.

Short selling is a form of speculation which involves significant risk and thus represents an advanced trading approach.

On the other hand, hedging, which involves establishing a counteracting position to mitigate exposure to risk, is a more widespread strategy.

To initiate a short position, an investor or trader must possess a margin account, which typically involves paying interest on the value of the borrowed shares for the duration of the position.

Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), are responsible for enforcing regulations concerning registered US brokers and broker-dealer firms.

Additionally, entities like the New York Stock Exchange (NYSE) and the Federal Reserve (the Fed) have established minimum thresholds for the maintenance margin—the mandated level for the margin account.

If the value of an investor’s account falls below this maintenance margin, he will need to put additional funds into the account. Otherwise, the broker might choose to liquidate the position.