Securities: Short Selling in the Stock Market

Short Sales and Stock Investing

What is a Short Sale?

Normally, when you invest in stocks, you buy them first and then sell them later. But with a short sale, it's the opposite. First, you sell the shares and then you buy them. In both cases, you start and end with no shares.

How Does a Short Sale Work?

In a short sale, you can make money when the price of a stock goes down. Here's how it works: You borrow a share of stock from someone and sell it. Later, you have to buy a share of the same stock to give back to the person you borrowed from. This is called "covering the short position."

Why Do People Short Sell?

When you short sell, you hope that the price of the stock will go down so that you can buy it back at a lower price. If that happens, you make a profit. But remember, when you short sell, you have to replace the shares you borrowed and also pay any dividends to the person you borrowed from.

How Does the Borrowing Work?

When you want to short sell, your broker (a person who helps you with buying and selling stocks) usually lends you the shares. The broker has shares from other investors that they can lend to you. The actual owner of the shares may not even know that their shares were lent to you. If the owner wants to sell their shares, the broker will borrow shares from someone else to replace them. This means that a short sale can continue for a long time. But if the broker can't find new shares to replace the ones you sold, you have to buy shares from the market and give them back to the broker to close the deal.

What about the Money?

When you make money from a short sale, the broker keeps that money in your account. You can't use that money to make more money. Also, you have to give some money or collateral (something valuable) to the broker as a backup in case the stock price goes up and you lose money. It's like a safety net.

Stop-Buy Orders

If you're short selling a stock, you might want to use something called a stop-buy order. Let's say you sold a stock for $100 per share, and if the price goes down, you make money. But if the price goes up to $130, you lose $30 per share. So, to protect yourself, you can set a stop-buy order at $120. If the price goes above $120, the order will be executed, and you will limit your losses to $20 per share. It's like having a line that says, "Stop! I don't want to lose too much money."

Short Selling and Financial Stress

Short selling sometimes gets criticized when the stock market is not doing well. After the 2008 financial crisis, the government made some rules to limit short sales when stocks fall by a lot. They want to make sure that people are not taking advantage of the bad situation.

What is Naked Short-Selling?

Naked short-selling is a bit different. It's when a trader sells shares that they haven't even borrowed yet. They think they will be able to get the shares before they have to give them back. This is not allowed, but some people still do it. Now, the government is making a rule that says you have to make sure you have the shares before you sell them.

How Does the Loan Change?

When you buy stocks with borrowed money (buying on margin), the loan amount stays the same no matter the share price. But with short selling, you borrow a certain number of shares, and you have to give them back. So, when the share price changes, the value of the loan also changes. It's a bit more complicated.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.