A short sale is sale in which the seller does not actually own the security that is sold. This simple statement can help you comprehend how short selling works in finance and especially when trading stocks, shares or financial securities.
How Short selling works
- Borrow shares from broker
- Sell the shares
- Buy shares from market
- Return the shares
The way this works is simple. As an investor, you anticipate that the price of shares will go down and therefore, you borrow and sell at the current market price and when the share price eventually falls, you buy from the market and return the shares. Say for example. You borrow 1000 shares of Company X, sell the shares at $20 each earning a total of $20,000. A few days later, the market price of the shares of company X falls to $17 per share. You therefore go to the market, buy the 1000 shares at a total of $17,000 and return the shares to the broker. By so doing, you have made a total of $3,000 in profit. Only works if indeed the share price goes down.
Note that an investor who buys and owns shares of stock is said to be long in the stock or to have a long position. An investor with a long position benefits from price increases (Buys low and Sells High), whereas, an investor with a short position benefits from price decreases (Sells High – buys low.)
Short interest: The amount of common stock held in short positions
In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. Note that with a short position, you may lose more than your total investment, as there is no limit to how high the stock price may rise.