Overview

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 (typically a fungible security such as a share or a bond) 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 (charged at a particular rate over time, similar to an interest payment) and reimburse the lender for any cash return (such as a dividend or interest) 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.

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 (or when the lender recalls the securities), 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 (or the other assets being sold short) 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.

Synthetic shorting with derivatives

"Shorting" or "going short" (and sometimes also "short selling") 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 (Vereenigde Oostindische Compagnie or VOC in Dutch).

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, apparently using customer deposits to cover losses.

The term short in the financial sense has been in use from at least the mid-nineteenth century. The word is used, in the sense of "lacking", because the short seller is in a deficit position with their brokerage house regarding the securities that they have borrowed.

Mechanism

A short seller typically borrows through a broker, who is usually holding the securities for another investor who owns the securities; the broker himself seldom purchases the securities to lend to the short seller. The lender does not lose the right to sell the securities while they have been lent, as the broker usually holds a large pool of such securities for a number of investors which, as such securities are fungible, can instead be transferred to any buyer.

In most market conditions there is a ready supply of securities to be borrowed, held by pension funds, mutual funds and other investors.