Short Selling

Q:
What is the concept of short selling?

A:
Short selling is the opposite of "going long." The short seller takes a fundamentally negative, or "bearish" stance, anticipating that the price of the shorted stock will fall (not rise as in long buying), and it will be possible to buy at a lower price whatever was sold, thereby making a profit ("selling high and buying low," to reverse the adage). The act of buying back the shares which were sold short is called 'covering the short'. Day traders and hedge funds often use short selling to allow them to profit on trading in stocks which they believe are overvalued, just as traditional long investors attempt to profit on stocks which are undervalued by buying those stocks.

The short seller 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 lend to the short seller.[4]

For example, to establish a 1,000-share short position of a stock trading at $100 per share, a person would borrow 1,000 shares from someone and then immediately sell them at a per share price of $100. If the stock were to drop ten percent in value the short trader could then elect to cover the position by buying back 1000 shares at $90 per share, for a profit of $10 per share, or $10,000.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate," and it is a legal requirement that U.S. regulated broker-dealers not permit their customers to short securities without first obtaining a locate. Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stock borrowed by U.S. brokers comes from loans made by the leading custody banks and fund management companies (see list below). Sometimes brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker cannot borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements.