Short Selling – What Does it Mean?

Everyone is talking about it… No one knows what it is.

Short selling or "shorting" is the practice of selling a financial instrument the seller does not own, in the hope of repurchasing it later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond.

Often the seller will "borrow" or "rent" the items to be sold, and later repurchase identical items for return to the lender. However, the practice is risky in that prices may rise indefinitely, even beyond the net worth of the short seller. The act of repurchasing is known as "closing" a position.

The term "short selling" or "being short" is often also used as a blanket term for strategies that allow an investor to gain from the decline in price of a security. Those strategies include buying options known as “puts”. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract means the holder of the position has an obligation to sell the underlying asset at a later date, to close out the position.

The problem in this market with the introduction of leveraged products such as margin loans, options, warrants and contracts for difference, is that investors are now able to enter into highly leveraged short positions. This causes market volatility as investors look to close out these highly leveraged positions and to some extent can distort market movements.

Most investors will never look to short the market, in fact most investors are long the market, that is, they buy stocks and hold them for the long term. Shorting has traditionally been a tool of the professional investor or broker and is a tool they used to insure positions.