Why does short selling require borrowing?

Question

Taking a 'long' position when investing is simple - you buy something (e.g a stock) with the hope it will appreciate in value, meaning you can then sell it and make a profit.

However, the reverse, going 'short' involves borrowing stock which you then sell, hoping it will depreciate in value, meaning you can then buy the same amount back again to give back to your lender and pocket the difference (your profit).

Now, what I'm struggling to understand is why the short selling concept must involve borrowing, whereas the long approach involves just dealing with your own stocks. Is it just because it would be pointless to try and short sell your own stocks as you wouldn't benefit from it?

Take a simple example of 'going short' but using your own shares:

1. ACME Corp is valued @ £2.00 per share
2. I purchase 10 shares @ £2.00 each, making my balance -£20.00
3. Then ACME Corp has some unexpected bad news, meaning its share price is likely to drop
4. It starts dropping, so I sell up (go short). I sell my 10 shares @ £1.50 each, making my balance -£5.00
5. The share price then hits what I think is rock bottom at £1.00 each, so I decide to buy them back. I buy 10 shares back at £1.00 each, making my final balance -£15.00

When you first look at the above, you think "I've made £5 out of the share price dropping", but...If I'd have just cut my losses and sold my shares once they started to drop, my balance would have been better at the end. Say for example if I just stopped after I'd sold at £1.50 each, my balance would still be -£5.00, which is better than the -£15.00 in the above example where I'm 'short selling' my own shares.

I'm sure this question has a very obvious answer, but I'm not confident that I have it worked out.

EDIT:

A simple way to ask the question might be to say "why can't I just use the same trick with my own shares to make money on the way down? Why is borrowing someone else's shares necessary to make the concept a viable one? Why isn't it just the inverse of 'going long'?"

Answer 1

why can't I just use the same trick with my own shares to make money on the way down?

Because if you sell shares out of your own portfolio, by definition, you are not selling short at all. If you sell something you own (and deliver it) - then there is no short involved.

A short is defined as a net negative position - i.e. you sell shares you do not have. Selling shares you own is selling shares you own - no short involved.

You must borrow the shares for a short because in the stock market, you must DELIVER. You can not deliver shares you do not own. The stock market does not work on promises - the person who bought the shares expects ownership of them with all rights that gives them. So you borrow them to deliver them, then return them when you buy them back.

Answer 2

In order to compare the two, you need to compare your entire portfolio, which is not just how much money you have, but how much stock. In both scenarios, you start with (at least, but let's assume) £20 and 0 stock.

In your scenario, you buy 10 shares, leaving you with £0 and 10 shares. You then sell it at £1.50/share to cut your losses, leaving you with £15 and 0 shares. That concludes the first transaction with a net loss of £5. In a second transaction, you then buy 10 shares again at £1/share, leaving you with £5 and 10 shares. You are still down £15 from the start, but you also still have 10 shares. Any further profit or loss depends on what you can get for those 10 shares in the future.

In a short sale, you borrow 10 shares and sell them, leaving you with £40 (your initial £20 plus what you just made on the short sale) and -10 shares of stock. At the end of the contract, you must buy 10 shares to return them; you are able to do so at £1.50/share, leaving you with £25 and 0 shares. At this point, your exposure to the stock is complete, and you have a net gain of £5.

Answer 3

Concerning the general problem of short selling and the need to borrow shares to complete the transaction :

Selling short is a cash transaction. Unlike a futures contract, where a short seller is entering into a legal agreement to sell something in the future, in the case of short selling a share the buyer of the share is taking immediate delivery and is therefore entitled to all of the benefits and rights that come with share ownership. In particular, the buyer of the shares is entitled to any dividends payable and, where applicable, to vote on motions at AGMs. If the short seller has not borrowed the shares to sell, then buyer of non-existent shares will have none of the rights associated with ownership.

The cash market is based on the idea of matching buyers and sellers. It does not accommodate people making promises.

Consider that to allow short sellers to sell shares they have not borrowed opens up the possibility of the aggregate market selling more shares than actually exist. This would lead to all sorts of problematic consequences such as heavily distorting the price of the underlying share. If everyone is selling shares they have not borrowed willy-nilly, then it will drive the price of the share down, much to the disadvantage of existing share holders. In this case, short sellers who have sold shares they have not already borrowed would be paying out more in dividends to the buyers than the total dividends being paid out by the underlying company.

There are instruments that allow for short selling of unowned shares on a futures basis. One example is a CFD = Contract for Difference. In the case of CFDs, sellers are obliged to pay dividends to buyers as well as other costs related to financing.

EDIT

Regarding your comment, note that borrowing shares is not a market transaction. Your account does not show you buying a share and then selling it. It simply shows you selling a share short. The borrowing is the result of an agreement between yourself and the lender and this agreement is off market. You do not actually pay the lender for the shares, but you do pay financing costs for the borrowing so long as you maintain your short position.

EDIT I realise that I have not actually read your question correctly. You are not actually talking about "naked" short selling. You are talking about selling shares you already own in a hope of maintaining both a long and short position (gross). The problem with this approach is that you must deliver the shares to the buyer. Otherwise, ask yourself what shares is the buyer actually buying if you want the bought shares to remain in your account. If you are not going to deliver your long position shares, then you will need to borrow the shares you are selling short for the reasons I have outlined above.

Answer 4

Selling short is simply by definition the selling, then later re-buying of stock you don't initially own.

Say you tally your entire portfolio balance: the quantity of each stock you own, and your cash assets. Let's call this your "initial position". We define "profit" as any increase in assets, relative to this initial position.

If you know a particular stock will go down, you can realize a profit by selling some of that stock, waiting for the price to go down, then buying it back. In the end you will have returned to your initial position, except you will have more cash.

If you sell 10 shares of a stock valued at £1.50, then buy them back at £1.00, you will make a £5.00 profit while having otherwise returned to your previous position.

If you do the same, but you initially owned 1000 shares, sold just 10 of those, then bought 10 back, that's still a profit of £5.00.

Selling short is doing the same thing, but with an initial and ending balance of 0 shares. If you initially own 0 shares, sell 10, then buy 10 back, you return to your initial position (0 shares) plus a profit of £5.00. (And in practice you must also pay a borrowing fee to do this.)

The advantage of selling short is it can be done with any stock, not just those currently owned.

Answer 5

This can be best explained with an example.

Bob thinks the price of a stock that Alice has is going to go down by the end of the week, so he borrows a share at $25 from Alice. The current price of the shares are $25 per share. Bob immediately sells the shares to Charlie for $25, it is fair, it is the current market price. A week goes by, and the price does fall to $20. Bob buys a share from David at $20. This is fair, it is the current market value. Then Bob gives the share back to Alice to settle what he borrowed from her, one share.

Now, in reality, there is interest charged be Alice on the borrowed value, but to keep it simple, we'll say she was a friend and it was a zero interest loan. So then Bob was able to sell something he didn't own for $25 and return it spending $20 to buy it, settling his loan and making $5 in the transaction.

It is the selling to Charlie and buying from David (or even Charlie later, if he decided to dump the shares), without having invested any of your own money that earns the profit.

Answer 6

You can't make money on the way down if it was your money that bought the shares when the market was up.

When you sell short, borrowing lets you tap into the value without paying for it. That way, when the price (hopefully) drops you profit from the difference.

In your example, if you hadn't paid the £20 in the first place, then you would actually be up £5. But since you started with £20, you still show loss.

As others said, borrowing is the definition of selling short. It is also simply the only way the math works. Of course, there is a large risk you must assume to enjoy benefiting from something you do not own!

Answer 7

From what I understand,

There is no way to take advantage of a future price drop in and of itself, if you cannot lock in the present price. The only way to lock in the present price is by borrowing the shares themselves, and then selling them right away. When you short sell you are locking in a contract in the present to deliver shares at a future date regardless of their price. So when you borrow the shares, you only need to deliver the same number of shares back. Since you believe that the price will go down, you believe that if you sell them now, you can buy them back at a lower price. Giving you both the shares needed to fulfill your contract, plus the profit difference between the higher price at present and the lower future price.

Basically, if you are right about the price drop, short selling gives you the same effect as going into the future, buying low, and coming back to the present and selling high.

Answer 8

A simple way to ask the question might be to say "why can't I just use the same trick with my own shares to make money on the way down? Why is borrowing someone else's shares necessary to make the concept a viable one? Why isn't it just the inverse of 'going long'?"

A simple way to think about it is this: to make money by trading something, you must buy it for less than you sell it for. This applies to stocks like anything else. If you believe the price will go up, then you can buy them first and sell them later for a higher price. But if you believe the price will go down, the only way to buy low and sell high is to sell first and buy later. If you buy the stock and it goes down, any sale you make will lose you money.

I'm still not sure I fully understand the point of your example, but one thing to note is that in both cases (i.e., whether you buy the share back at the end or not), you lost money. You say that you "made $5 on the share price dropping", but that isn't true at all: you can see in your example that your final account balance is negative in both cases. You paid $20 for the shares but only got $15 back; you lost $5 (or, in the other version of your example, paid $20 and got back $5 plus the depreciated shares).

If you had bought the shares for $20 and sold them for, say, $25, then your account would end up with a positive $5 balance; that is what a gain would look like. But you can't achieve that if you buy the shares for $20 and later sell them for less.

At a guess, you seem to be confusing the concept of making a profit with the concept of cutting your losses. It is true that if you buy the shares for $20 and sell them for $15, you lose only $5, whereas if you buy them for $20 and sell for $10, you lose the larger amount of $10. But those are both losses. Selling "early" as the price goes down doesn't make you any money; it just stops you from losing more money than you would if you sold later.

Answer 9

It's actually quite simple. You're actually confusing two concept. Which are taking a short position and short selling itself.

Basically when taking a short position is by believing that the stock is going to drop and you sell it. You can or not buy it back later depending on the believe it grows again or not. So basically you didn't make any profit with the drop in the price's value but you didn't lose money either.

Ok but what if you believe the market or specific company is going to drop and you want to profit on it while it's dropping. You can't do this by buying stock because you would be going long right?

So back to the basics. To obtain any type of profit I need to buy low and sell high, right? This is natural for use in long positions.

Well, now knowing that you can sell high at the current moment and buy low in the future what do you do? You can't sell what you don't have. So acquire it. Ask someone to lend it to you for some time and sell it. So selling high, check. Now buying low? You promised the person you would return him his stock, as it's intangible he won't even notice it's a different unit, so you buy low and return the lender his stock.

Thus you bought low and sold high, meaning having a profit.

So technically short selling is a type of short position. If you have multiple portfolios and lend yourself (i.e. maintaining a long-term long position while making some money with a short term short-term strategy) you're actually short selling with your own stock.

This happens often in hedge funds where multiple strategies are used and to optimise the transaction costs and borrowing fees, they have algorithms that clear (match) long and short coming in from different traders, algorithms, etc. Keep in mind that you while have a opportunities risk associated.

So basically, yes, you need to always 'borrow' a product to be able to short sell it. What can happen is that you lend yourself but this only makes sense if:

1. You have multiple portfolios;
2. They have different strategies using the same intangible product;
3. These strategies use different time spans;
4. The volume is big enough for the opportunity cost to be compensated by transaction/borrowing costs.