Short Selling

Short selling is the sale of a stock the seller does not own, usually borrowed through a broker, with the aim of buying it back later at a lower price; the loss is unlimited if the price rises instead.

How a short sale works

The SEC's Investor.gov glossary says a short sale occurs when you sell stock you do not own, and that if the price drops you can buy the stock back at the lower price and profit, while if it rises you incur a loss. Under the SEC's Regulation SHO, a broker-dealer must have reasonable grounds to believe the security can be borrowed so that it can be delivered on the settlement date before executing a short sale, known as the locate requirement, and must close out failures to deliver by purchasing or borrowing securities of like kind and quantity. Short sales are made in a margin account: the broker lends the shares, the proceeds are held as collateral, and the short seller pays borrowing fees, posts margin and owes the lender any dividends paid while the position is open.

Hypothetical example: an investor shorts 100 shares at $50. Covering at $40 yields a gross profit of $1,000 before fees; covering at $70 produces a $2,000 loss. See leverage and the margin call calculator.

The risks specific to short positions

A long position can lose at most its purchase price, but a short position's loss grows without limit as the price rises, and a stock can rise far more than 100%. Because the position is held on margin, a rising price also erodes the account's equity and can trigger a margin call requiring additional cash or forced repurchase at unfavorable prices. Borrowing costs vary with how hard the shares are to locate and can climb sharply when many investors want to short the same stock, and lenders can recall shares, forcing a buy-in regardless of price. A rapid rise that forces many short sellers to buy back at once is called a short squeeze. Regulation SHO's close-out rules can also force purchases. Short selling is used both to speculate on declines and as a hedge against long positions.

Hypothetical example: the same short is opened with $2,500 of the investor's own margin. A rise to $75 shows a $2,500 loss, wiping out that margin. See the stock buying power calculator and put options for a defined-risk alternative.