What is short selling?

What is short selling?

If you expect that a security will depreciate, you can sell it on the market without owning it, and, if your expectations prove to be right, you can buy it for less before “covering” your position – keeping the difference in profit.

Short selling is done with the help of a brokerage/custodian, who will lend you the security so that you can sell it, and they will charge interest on the loaned amount until you actually purchase the security to “cover” your loan.

Short selling is a bearish position, in which the investor bets that the security will depreciate enough in the future to make it worth the trouble of borrowing it from the brokerage, selling it to a third party, paying interest on the loan and leaving collateral (margin) in place, before finally buying it at a (hopefully) lower price and giving it to the brokerage since they loaned the security to the investor originally.

The investor’s margin account must have enough cash and margin-able securities to borrow the securities being sold short, but the premium that will be collected on the sale can be factored in. Often, the premium collected for short selling is the sweetener that makes the sale worth doing.

It may take the edge off of the price of a long position, or it may give the investor excess equity that will allow other margin transactions. Short selling can be done with equities and all kind of options. Investors must remember that there is a distinct risk that the security will appreciate instead of depreciating.

The short-seller would then be exposed to the risk of purchasing the stock at whatever price it had reached in order to cover the loaned shares. It might be wise in that position to purchase a call option at a higher price than expected just so the price doesn’t run away too much.

The short seller must also pay any dividends forward from the time of the short sale to the lender, despite the fact that those dividends will not be priced into the future value of the shares.