What Is: Short-Selling a Stock
Short-selling, also referred to as “Shorting”, is a type of sale of securities. Think of “Securities” as a portfolio of financial assets; stocks are just one facet of that portfolio. There are two traditional ways to go about buying and selling stock, the first is the most obvious and simplest to understand, selling long.
“Selling Long”
To “sell long” the individual must first make a stock purchase when that stock is at a perceived low. In selling long, the stock buyer purchases the share(s) because he believes that the current listed stock price is at a perceived lower than typical rate.
Then, because the stock buyer purchased said share(s) at a perceived low, he maintains his shareholder status until the stock price increases. After the increase, the shareholder will sell his shares when the stock reaches a perceived high. This type of stock buyer only profits when he buys shares at a low value, and banks on the possibility of a stock price increase.
“Selling Short” (AKA Stock Shorting)
To “Sell Short” the individual must sell a stock share(s) when that stock is at a perceived high. This is called “selling high”. In selling high, the shareholder sells his shares at the perceived highest value because he believes the stock price will drop exponentially.
Then, when the shareholder relinquishes his share(s) at a high value, he must wait for the stock price per share to drop to a perceived low to make a profit upon repurchasing. This type of stock buyer only profits when he sells shares at their most profitable, and banks on that stock dropping in value so that he may repurchase the stock at a discounted rate and profit off of the difference (high return).
However, the main difference between “selling long” and “selling short” is that short-selling exclusively deals with borrowed stock. This means that in short selling there is an extra step to complete the selling transaction because you, the investor, do not personally own the stock. Instead, you the investor, would have to involve a brokerage.
A stock brokerage is essentially the middleman between buyers and sellers of stocks. These brokerages maintain a portfolio of clients and act as a type of matchmaker between buyers and sellers to yield the best profit for the brokerage.
Let’s say you the investor decided that you wanted to short-sell a stock. The process would incur as follows:
1. The Investor borrows a specified amount of shares of ‘xyz stock’ from a brokerage.
2. Those borrowed stocks are held in the investor’s brokerage account.
3. The Investor sells however many shares they borrowed from the brokerage at the “perceived high”.
4. If the stock the investor sold drops in price per share (i.e., from 10 dollars per share to 5 dollars per share) the investor profits off the difference
5. If the stock the investor sold increases in price per share (i.e., from 5 dollars per share to 10 dollars per share) the investor would have to pay back the brokerage the stock price difference (i.e., you borrow stock at 5 dollars per share, the stock increases to 10 dollars per share, you are obligated to pay back an additional yield of five dollars per share borrowed).
6. Regardless of whether the investor receives a profit or incurs debt from a borrowed security, they must also pay brokerage fees. A brokerage fee can resemble something like an interest rate. This fee would be subtracted from the total returns before they can cash out the account, or added to the total brokerage bill if no returns were yielded.
Needless to say, “Shorting” at its base level is a highly volatile form of securities trade with high risk, but equally high reward. Objectively speaking, short-selling is typically reserved for experienced traders or market makers.
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