The Strategy and Risk of Short Selling

Short selling is selling a stock that the seller doesn’t own. Investors will often “short” a stock for which they anticipate a decrease in share price. By contrast, an investor “goes long” on a stock (buys it) when they believe its share price will rise in the future. Short selling reverses the concept of buying low and selling high.

When an investor chooses to short sell a stock they borrow it from a broker. The seller must often use other stock holdings as collateral. The shares are then sold with the proceeds credited to the seller’s account. The seller makes money when they close the position by buying back the same number of shares to “cover” the position with the broker. As long as the price has dropped, as the seller has anticipated, they make money in the transaction.

If, however, the stock price has risen, the seller loses money on the transaction. The fact that prices can rise, perhaps dramatically, is what makes the practice of short selling risky.

Please note that the SEC prohibits short selling of stocks whose prices are falling (the “uptick rule”). The rule was put in place in an effort to prevent short sellers from driving down the price of a stock that is already in decline.

While the investor’s short sale is outstanding, his account is typically charged interest against the value of the position. If the shorted stock price goes up, or the value of the collateral stock goes down in price, the investor may be required to deposit money to their margin account or buy back the stock shorted stock.

As it pertains to the economy as a whole, widespread short-selling was blamed (at least in part) by many government officials and financial experts for the recent collapse of several large financial companies (including Lehman Brothers) as the practice drove their share prices down. In response, the Securities and Exchange Commission temporarily banned the practice.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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