Short Selling

Short selling means selling securities, for example shares, that the seller does not own. The broker accepts the order and borrows the shares from a portfolio in order to sell them short; the actual owner of the shares does not have to be informed of this. The trader is betting on falling prices and wants to profit from the difference between the selling price and the later purchase price: the aim is to buy the shares back more cheaply and return them to the lender.

Example and risks

Example: a trader expects a company's shares to fall and sells 100 borrowed shares at $60, receiving $6,000. A few weeks later, the price has dropped to $50. The trader buys back 100 shares for $5,000 and returns them to the lender. The profit is $1,000, minus costs such as the fee for borrowing the shares. Had the price risen to $70 instead, buying back would have cost $7,000 – a loss of $1,000.

Because a share price can in theory rise without limit, the potential loss on a short sale is also unlimited, while the maximum profit is limited to the selling price. The short seller also usually has to compensate the lender for dividends paid in the meantime.

Covered and naked short selling

A distinction is made between covered and naked (uncovered) short selling. In a covered short sale, the seller has borrowed the securities, or secured the right to borrow them, before selling. In a naked short sale, the securities are sold without having been borrowed or located beforehand. Naked short selling is restricted in many jurisdictions, for example for shares in the European Union.

Short positions in forex and CFD trading

In forex and CFD trading, going short is much simpler: the trader opens a short position with a sell order, without having to borrow anything. In forex, every trade involves buying one currency and selling another anyway – selling EUR/USD simply means betting that the euro will fall against the US dollar. A short position is closed by buying back the same quantity. Short positions can also hedge existing long positions against falling prices.