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Can someone please explain the meaning of 'shorting' a stock with an example?

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Could anyone elaborate on the etymology of the words. What is the metaphore behind "short position" and "long position"? Is "long position" meaning you are holding the stocks for a long time, expecting long growth? –  dhill Nov 17 '11 at 17:53
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3 Answers 3

up vote 17 down vote accepted

This is a gross simplification as there are a few different ways to do this. The principle overall is the same though.

To short a stock, you borrow X shares from a third party and sell them at the current price. You now owe the lender X shares but have the proceeds from the sale. If the share price falls you can buy back those shares at the new lower price, return them to the lender and pocket the difference.

The risk comes when the share price goes the other way, you now owe the lender the new value of the shares, so have to find some way to cover the difference. This happened a while back when Porsche made a fortune buying shares in Volkswagen from short sellers, and the price unexpectedly rose.

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Rich's answer captures the basic essence of short selling with example.

I'd like to add these additional points:

  • You typically need a specially-privileged brokerage account to perform short selling. If you didn't request short selling when you opened your account, odds are good you don't have it, and that's good because it's not something most people should ever consider doing. Short selling is an advanced trading strategy. Be sure you truly grok selling short before doing it.

  • Consider that when buying stock (a.k.a. going long or taking a long position, in contrast to short) then your potential loss as a buyer is limited (i.e. stock goes to zero) and your potential gain unlimited (stock keeps going up, if you're lucky!)

    Whereas, with short selling, it's reversed: Your loss can be unlimited (stock keeps going up, if you're unlucky!) and your potential gain is limited (i.e. stock goes to zero.)

  • The proceeds you receive from a short sale – and then some – need to stay in your account to offset the short position. Brokers require this. Typically, margin equivalent to 150% the market value of the shares sold short must be maintained in the account while the short position is open.

  • The owner of the borrowed shares is still expecting his dividends, if any. You are responsible for covering the cost of those dividends out of your own pocket.

  • To close or cover your short position, you initiate a buy to cover. This is simply a buy order with the intention that it will close out your matching short position.

  • You may be forced to cover your short position before you want to and when it is to your disadvantage! Even if you have sufficient margin available to cover your short, there are cases when lenders need their shares back. If too many short sellers are forced to close out positions at the same time, they push up demand for the stock, increasing price and deepening their losses. When this happens, it's called a short squeeze.

  • In the eyes of the public who mostly go long buying stock, short sellers are often reviled. However, some people and many short sellers believe they are providing balance to the market and preventing it sometimes from getting ahead of itself.

  • [Disambiguation: A short sale in the stock market is not related to the real estate concept of a short sale, which is when a property owner sells his property for less than he owes the bank.]

Additional references:

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@Chris Are there any costs involved with short selling? –  gyurisc Mar 24 '10 at 5:30
    
Similar commission as when selling a stock you own. Also, as mentioned, if it's a dividend paying stock you must pay the dividend to the guy who lent you his stock to short. –  JoeTaxpayer Nov 7 '10 at 1:45
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@joetaxpayer : Wouldn't the guy also charge a fee for lending you the stock? –  Joe.E Jun 21 '11 at 5:10
    
@Joe E - only for shares that are tough to short. There's a small number of shares that are either so closely held or highly shorted already, that brokers will pay a monthly fee to the guy they borrow from, in some cases far higher than a dividend. –  JoeTaxpayer Jun 21 '11 at 11:05
    
@JoeTaxpayer Excellent clarifications! The fee for borrowing the stock is often what makes a short selling strategy uneconomic. Often the best stocks to short for arbitrage set-up's cost too much to borrow. –  Feral Oink Oct 10 '11 at 9:57
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I believe the term "short" comes from the popular phrase "I'm a little short..." which means you don't have enough money to pay for something.

In most cases, it implies the person will agree to sell you something even though you don't have enough money right now, and you can pay them for it later.

So in the case of stocks, they let you own the stocks without you paying for them at the time of the transaction. This implies they are giving you financial credit to get something now and pay for it later, similar to a credit card purchase.

The reason for selling a stock "short", is for when you believe the stock value will decrease in the near future.

Here is an example: Today Exxon-Mobile stock is selling for $100 / share. You are expecting the price to decrease, so you want to short the stock, which means your broker (i.e. eTrade, etc) allows you to borrow shares without paying money, and those shares are transferred into your account, and then you sell them and receive money for the sale. But you didn't actually own those shares, you only borrowed them, so you need to return the shares to your broker sometime in the future.

Let's say you borrow 10 shares @ $100, and you sell them at the market price of $100, you receive $1,000 in your account. But you owe your broker 10 shares, which you need to return sometime in the future.

A few days later, the share price has decreased to $80. Now you can buy 10 shares from the market at a total cost of $800. You get 10 shares, and return those shares to your broker. Since you originally took in $1,000, and you just paid out $800, you keep a resulting profit of $200

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