Short Selling Explained

Short selling is a kind of trading strategy which can be used as a part of portfolio hedging strategy as well as for speculating in the market. Short traders follow some steps when selling short and try to benefit from selling overvalued asset which they don't own and was borrowed from broker.

Short selling: definition

Short selling concept is the reverse of the equation “buy low, sell high”. One can "sell high, buy low" using short selling. Short position is the opposite of a long position, so many features are inversed. Particularly, in case of short selling, the feasible profit (instead of the loss) is limited to the value of asset, but the eventual loss is unlimited.

In case of short selling trader efficiently buys low and sells high but just in the reverse order.  This means that, in order to sell first, one must sell an asset that s/he does not own. Short selling refers to the process of selling an asset that the seller doesn't own. This may sound confusing, but it's a simple concept. Since the investor doesn’t own the security, s/he typically borrows it from a dealer/broker and shorts it in the market. In the future, the investor will obtain the security from the market at a current market price and return it to the lender. If the asset price has fallen, the investor will make a profit from the deal. Short investors are trying to make a profit by shorting securities that they consider overvalued, just as traditional long investors try to profit by getting hold of undervalued assets. The investor also has to pay a fee to the lender for the borrowed security, known as the borrowing costs. 

Short selling: reasons

Shorting as an active investing strategy is used by very few sophisticated money managers. The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions. If an investor chooses to only buy an asset, then s/he can only make money on securities whose prices rise. But if an investor also adds short sales to his/her trading arsenal, then s/he can profit from assets whose prices rise or fall. Hedging can be an advantage because an investor is insuring his/her portfolio against risk, but it can also be expensive and a basis risk may occur. A portfolio, including both long and short positions in assets that tend to move together, usually has lower volatility than the one with only long positions.

Overall, the two main reasons of short trading are either hedging or speculating. When speculating, investor is looking for fluctuations on the market with а view to quickly make a large profit of a high-risk investment.

Speculating differs from hedging because speculators deliberately assume the risk, whereas hedgers seek to mitigate it. Speculators meet big rewards, but they also accept a high loss if they use wrong strategies at a wrong time. 

Short selling:  process

The process of selling asset short consists of the following five steps:

  1. Find overvalued securities. Analyze the market and look for an asset with falling prices.
  2. Borrow the asset to bet against. Contact a broker to find assets that probably will go down and request to borrow the shares. The broker then contacts another investor who owns the shares and borrows them with a promise to return the shares later at a prearranged date and lends them to investor.
  3. Sell the borrowed asset. Land the security then sell. The proceeds from the sale are deposited on the investor's brokerage account.
  4. Cover the short position. An investor patiently waits for the price of the asset to drop, and then closes position by buying back the shares.
  5. Return the borrowed shares. The investor returns the shares to the brokerage s/he borrowed them from and pockets the difference.