A short stock position is initiated by a trader in order to profit from a decline in the stock’s price. A trader initiates a short by selling shares of a stock that he does not own. If the stock’s price falls, the trader can then “cover his position” by buying the stock back from the open market and profiting from decline in price.
When a trader sells a stock that he does not own, his account is credited with the value of the sale. At the same time, there is a debit in the account for the quantity of shares that he borrowed to sell. If the stock does indeed fall in value and the trader wishes to realize his profit, the trader will purchase the shares from the open market and replace the borrowed shares. This is known as covering the short. The trader’s profit is then the difference between the amount of money he made from selling the borrowed shares, and the amount of money it costs to replace the borrowed shares. Similarly, if the price increases in value, the trader will lose the difference between the proceeds of the sale and the cost of the purchase.
Besides expecting a decline in a securities price, a trader or firm may initiate a short position in order to hedge another position. This will protect the trader or firm from future volatility in the hedged position. If the hedged position performs as expected, the gains will be offset by the loss in the short position. If the hedged position losses value, the loss should be offset by a gain in the short position. This is a strategy used by many firms and traders to mitigate risk.
A trader can short a stock as long as he is able to borrow shares that he does not own. While this seems impossible, it is not, and in fact it is a very common practice. Borrowing stock for shorting is facilitated by the brokerage, and in most instances the shares will be borrowed from the brokerages own inventory. If the brokerage does not have the needed shares in their own inventory, they can borrow the shares from another brokerage or from another client’s margin account. There are firms that specialize in facilitating these transactions and they often find and borrow the shares from large institutions or pension funds. This is known as a “stock locate” or “locating stock”. A trader or firm must be able to locate the stock before the short is initiated, this requirement is known as Regulation SHO. If the trader does not locate the stock and can not deliver the sold shares to the purchaser during the 3 day clearing deadline, it is known as a “naked short”. The SEC has a great description of of the mechanics of short sales and the legal requirements here.
Traders should remember that brokerages will charge interest fees for the stock that is being borrowed, so there is a decaying value to holding a short position open over time.
Example of a Profitable Short Sale
A trader shorts 500 shares of stock ABC at $10. The trader’s account will be credited with the proceeds of this transaction, $5,000. The trader also has a debit to replace the 500 shares that he borrowed. The stock falls in price to $9.00. The trader decides to take his profit and cover his short position. He buys 500 shares back at $9.00, for a total cost of $4,500. The trader will make the difference between the proceeds of the sale $5,000, and the cost of the purchase $4,500 for a total profit of $500 (minus all commission and interest charges).
The ability to short a stock is important for a trader or firm to profit from declines in price. It is important both as an opportunity to capitalize on a drop in price for profit, and to mitigate risk as part of a hedging strategy.