Short (finance)


In finance, being short in an asset means investing in such a way that the investor will profit if the market value of the asset falls. This is the opposite of the more common long position, where the investor will profit if the market value of the asset rises. An investor that sells an asset short is, as to that asset, a short seller.
There are a number of ways of achieving a short position. The most fundamental is physical selling short or short-selling, by which the short seller borrows an asset and sells it. The short seller must later buy the same amount of the asset to return it to the lender. If the market price of the asset has fallen in the meantime, the short seller will have made a profit equal to the difference in price. Conversely, if the price has risen then the short seller will bear a loss. The short seller usually must pay a borrowing fee to borrow the asset and reimburse the lender for any cash return that would have been paid on the asset while borrowed.
A short position can also be created through a futures, forward, or option contract, by which the short seller assumes an obligation or right to sell an asset at a future date at a price stated in the contract. If the price of the asset falls below the contract price, the short seller can buy it at the lower market value and then sell it at the higher price specified in the contract, and thereby benefit from the lower price. A short position can also be achieved through certain types of swap, such as a contract for difference, which is an agreement between two parties to pay each other the difference if the price of an asset rises or falls, under which the party that will benefit if the price falls will have a short position.
Because a short seller can incur a liability to the lender if the price rises, and because a short sale is normally done through a broker, a short seller is typically required to post margin to its broker as collateral to ensure that any such liabilities can be met, and to post additional margin if losses begin to accrue. For analogous reasons, short positions in derivatives also usually involve the posting of margin with the counterparty. A failure to post margin when required may prompt the broker or counterparty to close the position at the then-current price.
Short selling is a common practice in public securities, futures, and currency markets where the assets are fungible and reasonably liquid. It is otherwise uncommon, because a short seller needs to be confident that it will be able to repurchase the right quantity of the asset at or around the market price when it decides to close the position.
A short sale may have a variety of objectives. Speculators may sell short hoping to realize a profit on an instrument that appears overvalued, just as long investors or speculators hope to profit from a rise in the price of an instrument that appears undervalued. Alternatively, traders or fund managers may use offsetting short positions to hedge certain risks that exist in a long position or a portfolio.
Advocates of short selling argue that the practice is an essential part of the price discovery mechanism, but short selling is subject to criticism and periodically faces hostility from society and policymakers because it is perceived to put downward pressure on prices. Nevertheless, research indicates that banning short selling is ineffective and has negative effects on markets.

Concept

Physical shorting with borrowed securities

To profit from a decrease in the price of a security, a short seller can borrow the security and sell it, expecting that it will be cheaper to repurchase in the future. When the seller decides that the time is right, the seller buys the same number of equivalent securities and returns them to the lender. The act of buying back the securities that were sold short is called covering the short, covering the position or simply covering. A short position can be covered at any time before the securities are due to be returned. Once the position is covered, the short seller is not affected by subsequent rises or falls in the price of the securities, for it already holds the securities that it will return to the lender.
The process relies on the fact that the securities are fungible. An investor therefore "borrows" securities in the same sense as one borrows a $10 bill, where the legal ownership of the money is transferred to the borrower and it can be freely disposed of, and different bank notes or coins can be returned to the lender. This can be contrasted with the sense in which one borrows a bicycle, where the ownership of the bicycle does not change and the same bicycle must be returned, not merely one that is the same model.
Because the price of a share is theoretically unlimited, the potential losses of a short-seller are also theoretically unlimited.

Worked example of a profitable short sale

Shares in ACME Inc. currently trade at $10 per share.
  1. A short seller borrows from a lender 100 shares of ACME Inc., and immediately sells them for a total of $1,000.
  2. Subsequently, the price of the shares falls to $8 per share.
  3. Short seller now buys 100 shares of ACME Inc. for $800.
  4. Short seller returns the shares to the lender, who must accept the return of the same number of shares as was lent despite the fact that the market value of the shares has decreased.
  5. Short seller keeps as its profit the $200 difference between the price at which the short seller sold the borrowed shares and the lower price at which the short seller purchased the equivalent shares.

    Worked example of a loss-making short sale

Shares in ACME Inc. currently trade at $10 per share.
  1. A short seller borrows 100 shares of ACME Inc., and sells them for a total of $1,000.
  2. Subsequently, the price of the shares rises to $25 per share.
  3. Short seller is required to return the shares, and is compelled to buy 100 shares of ACME Inc. for $2,500.
  4. Short seller returns the shares to the lender, who accepts the return of the same number of shares as was lent.
  5. Short seller incurs as a loss the $1,500 difference between the price at which they sold the borrowed shares and the higher price at which the short seller had to purchase the equivalent shares.

    Synthetic shorting with derivatives

"Shorting" or "going short" also refer more broadly to any transaction used by an investor to profit from the decline in price of a borrowed asset or financial instrument. Derivatives contracts that can be used in this way include futures, options, and swaps. These contracts are typically cash-settled, meaning that no buying or selling of the asset in question is actually involved in the contract, although typically one side of the contract will be a broker that will effect a back-to-back sale of the asset in question in order to hedge their position.

History

The practice of short selling was likely invented in 1609 by Dutch businessman Isaac Le Maire, a sizeable shareholder of the Dutch East India Company.
The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major crisis that included the collapse of almost every private bank in Scotland, and a liquidity crisis in the two major banking centres of the world, London and Amsterdam. The bank had been speculating by shorting East India Company stock on a massive scale, and apparently using customer deposits to cover losses.
The term short was in use from at least the mid-nineteenth century. It is commonly understood that the word "short" is used because the short seller is in a deficit position with their brokerage house regarding the securities that they have borrowed.
Jacob Little, known as The Great Bear of Wall Street, began shorting stocks in the United States in 1822.
Short sellers were one of the groups blamed for the Wall Street crash of 1929. Regulations governing short selling were implemented in the United States in 1929 and in 1940. Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick; this was known as the uptick rule and was in effect until 3 July 2007, when it was removed by the Securities and Exchange Commission. President Herbert Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression.
In 1949, Alfred Winslow Jones founded a fund that bought stocks while selling other stocks short, hence hedging some of the market risk, which is generally considered to be the first hedge fund.
George Soros was blamed for "breaking the Bank of England" on Black Wednesday in 1992, when he sold short more than $10 billion worth of pounds sterling.
During the 2008 financial crisis, critics argued that investors taking large short positions in struggling financial firms like Lehman Brothers, HBOS and Morgan Stanley created instability in the stock market and placed additional downward pressure on prices. In response, a number of countries introduced restrictive regulations on short-selling in 2008 and 2009. Naked short selling is the practice of short-selling a tradable asset without first borrowing the security or ensuring that the security can be borrowed, intending to do so after agreeing the sale in order to be able to settle with the settlement period – it was this practice that was commonly restricted. Investors argued that it was the weakness of financial institutions, not short-selling, that drove stocks to fall. In September 2008, the Securities Exchange Commission in the United States abruptly banned short sales, primarily in financial stocks, to protect companies under siege in the stock market. That ban expired several weeks later as regulators determined the ban was not stabilizing the price of stocks.
Temporary short-selling bans were also introduced in the United Kingdom, Germany, France, Italy and other European countries in 2008 to minimal effect. Australia moved to ban naked short selling entirely in September 2008. Germany placed a ban on naked short selling of certain Eurozone securities in 2010. Spain, Portugal and Italy introduced short selling bans in 2011 and again in 2012.
During the COVID-19 pandemic, shorting was severely restricted or temporarily banned, with European market watchdogs tightening the rules on short selling "in an effort to stem the historic losses arising from the coronavirus pandemic".
In addition to attempted bans, regulators in many jurisdictions require the disclosure of short positions, in order to improve the information in the market regarding the extent of the short interest in particular companies.
Worldwide, economic regulators seem inclined to restrict short selling to decrease potential downward price cascades. Investors continue to argue this only contributes to market inefficiency.