What is Short Selling & How does it Work?

Short selling is also known as shorting. When the seller shares a share that he/she does not own it is known as short selling. To be more specific it is when the seller sells a share or a security that he/she does not own, but has promised to deliver it. This is in complete contrast with the process of selling long. This means exactly the opposite. This involves the purchasing of a security whose price is expected to rise. Whenever you sell a stock short, your broker is the one who lends it to you.

There are several sources that a broker can get it from. It can come from the shares the broker already owns, it can be a share from one of the other customers of the same firm, or it can also be from some other brokerage firm. Once the shares are sold, the amount is credited to your account. Once the money is credited to your account, you must buy back exactly the same number of shares. This is known as covering. These shares are then returned to your broker. If the price of the said stock drops, what you have done is bought back the same share at a lower price. Thus you end up making a net profit.


However, if the price of the share rises, then you have made a loss. This is because you sold at a higher price, hoping to cover your sale at a lower price, and that did not happen. In most cases you can keep a short held stock for as long as you want to. But in case the person who has lent the shares to you wants the shares back, then you have to sell the shares back to the lender. In such cases a brokerage firm cannot sell what it does not have. So you have few options. You need to arrange the shares from somewhere to return them to the lender. Or you need to cover. This is referred to as being called away. You don't have the stock anymore since you sold it. So, you also need to surrender to the lender any of the dividends or rights that may be related to the said shares. You also need to open a Margin account for short selling, the broker or brokerage house will insist you put a certain amount of money and only then you can trade, they will be using that as a back–up for contingencies.

Let us take an example. Company X is performing very badly. The prices are dropping. You buy shares at a price of $10. Then the share value drops to $8. Now you short sell the shares and make a net profit of $2 per share. But if the price goes up to $11, you make a loss of $1 per share.