What is Short Selling?

Mary McMahon
Mary McMahon

Short selling is a practice in which people take a “short” position on a stock, hoping that the value of the stock will decline and they can profit on the falling price. There are several ways in which people can take a short position on stocks. This practice is regulated in most markets due to concerns that short selling activities could potentially expose people and the market to risks.

Short selling allows investors to profit from a declining stock price.
Short selling allows investors to profit from a declining stock price.

One way to short sell is to borrow a security from a broker and sell it at the current high price, with the understanding that the borrowed securities will have to be returned. The short seller can wait for the price to drop and buy back shares at the lower price, returning these shares to the broker. If the short seller bargained wrong and the price went up, she or he still has to cover the short sale and will lose money buying back shares to return.

In real estate “short sale,” a bank agrees to accept less than the outstanding amount on a loan in order to resolve a mortgage debt.
In real estate “short sale,” a bank agrees to accept less than the outstanding amount on a loan in order to resolve a mortgage debt.

People can hold a short position for varying lengths of time. Many brokers do not have firm limits on the return of borrowed securities, but they will charge interest on the loan. In addition, they can call the loan and demand that the buyer return the borrowed shares. When people engage in this type of short selling, the lender also receives a cut of the profits and can charge fees.

Another option is to write a futures contract to sell a security to someone in the future at the current price. In this case, the person who holds the contract waits for the price of the security to drop, buys up shares at the low price, and then turns around and resells them under the terms of the contract at the higher price. Like the other form of short selling, this method involves selling securities which someone does not actually have in hand.

People may also see the term “short sale” used in the real estate market. This type of short selling is a slightly different concept. In this case, a bank agrees to accept less than the outstanding amount on a loan in order to resolve a mortgage debt. People often attempt to negotiate a short sale before a bank forecloses on a property. The borrower will still have a negative mark on his or her credit record, but less of a mark than would be incurred by foreclosure proceedings, and the bank in turn benefits because it does not need to deal with selling the property after foreclosure.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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