A market transaction in which an investor sells borrowed securities in
anticipation of a price decline and is required to return an equal
amount of shares at some point in the future.
The payoff to selling short is the opposite of a long position. A
short seller will make money if the stock goes down in price, while a
long position makes money when the stock goes up. The profit that the
investor receives is equal to the value of the sold borrowed shares
less the cost of repurchasing the borrowed shares.
Suppose 1,000 shares are short sold by an investor at $25 apiece and
$25,000 is then put into that investor’s account. Let’s say the shares
fall to $20 and the investor closes out the position. To close out the
position, the investor will need to purchase 1,000 shares at $20 each
($20,000). The investor captures the difference between the amount
that he or she receives from the short sale and the amount that was
paid to close the position, or $5,000.
There are also margin rule requirements for a short sale in which 150%
of the value of the shares shorted needs to be initially held in the
account. Therefore, if the value is $25,000, the initial margin
requirement is $37,500 (which includes the $25,000 of proceeds from
the short sale). This prevents the proceeds from the sale from being
used to purchase other shares before the borrowed shares are returned.
Short selling is an advanced trading strategy with many unique risks
and pitfalls. Novice investors are advised to avoid short sales
because this strategy includes unlimited losses. A share price can
only fall to zero, but there is no limit to the amount it can rise.