What is Short Selling?

So you are interested in learning more about short selling and the benefits it can provide you.  Short selling in a nutshell is the borrowing of a stock, selling a stock short, and repurchasing the same stock once the market drops to a lower level so that the trader can profit from the decline of the security. 

There are several types of short sales a trader should be cognizant of.  A trader/investor can include short sales into their portfolio strategies which can include pair trading, directional short sales, and option strategies.  Investors and traders have historically used short selling strategies to hedge against risk exposure.   In addition, short selling can be classified as either a covered short sale or naked short sale. 

Again, there are different strategies when short selling.  A covered short sale of a security only transpires if the trader/investor has a margin account.  With a margin account the investor/trader will be able to borrow funds against the security and then sell the security short.   The security is borrowed by using the stock as collateral which is then sold and repurchased at hopefully a lower price. 

The most widely used strategy with a short sale is a directional trade.  The directional trade takes place when the short seller is looking for a specific security price to drop.   Another popular trading strategy which uses short sales is pair trading.   When pair trading takes place a trader/investor purchases one security and at the same time short sells a different security that is in a similar business.   Pair trades usually involve securities that move in sequence with one another and also have highly correlated returns. 

Typically, the rule of thumb is that securities that are not liquid are harder to borrow than those that are more liquid.  When a covered short sale trade takes place the lender is collateralizing the deal against the security that will be returned to them by the short seller.  Traders/investors consider this covered because the short sale is covered by a security that was borrowed. 

Short selling can take place without a trader/investor borrowing the underlying security.  When this takes place it is what you would call a naked short sell.  Even though traders/investors should borrow a security before short selling the security, this procedure can’t always be accomplished. 

You may ask yourself why does naked short selling take place.  The simple answer is that a situation can take place where the inventory of a specific security is limited and shares of the security to be borrowed is limited as well.  The expense which is associated to the borrowing of an illiquid security specifically the interest rate that the lender may charge could be cost prohibitive. 

When a short sale transaction takes place the security must be acquired prior to the delivery period.  If the short seller of a security does not purchase the security before this period, this is known as a failure to deliver.  When this type of transaction takes place it remains open until the security is acquired by the seller or closed by the broker of the seller. 

In closing, short selling plays an important role in a trader/investors strategy.  When short sales are used correctly they not can protect trader/investors portfolios and act as insurance against lose.  There are several types of short sales and when used correctly will reap benefits.