What is Short Selling? Definition And Use Cases

The concept of “short trades” or “Going Short” has been formed relatively recently, when the seller borrowed stocks from his/her broker for a quick sale. The seller didn’t own the asset and hoped to buy it later at a lower price. In essence, to “sell short” means to “go long” with a view to sell an asset and buy it back in the future at a lower price. Traders who prefer this strategy are called “bears”.

The opposite strategy is called “Going Long”. It is used by the traders who consider themselves as “bulls”. In both cases, we’re talking about margin trading, which allows you to trade amounts that greatly exceed your existing funds.

How to sell a stock short?

Usually, a trader who assumes that the move down will persist long enough borrows assets (stocks, fiat money, bitcoins, etc.) from a broker to quickly sell it at the current price. The main purpose of such trade is to profit from a drop in the stock price. Short trades always involve high risks, especially when it comes to the assets of the new companies with unlimited growth potential. Such assets are usually purchased by the “bulls” who hope to profit from the increase in stock prices.

“Bears” usually use the tactics “sell short” (i.e. without buying/covering stocks) within the framework of margin trading, where one can use high leverage. In this case, the risks, as well as potential profits, can be large enough. If the stock doesn’t bottom, you may go into the red. Usually, only aggressive/self-confident traders or investors who have unique inside information play such risky games. 

In short selling, experienced traders take a neutral position, waiting for the “bearish trend” (a downward trend in the prices of an industry’s stocks). If the seller timely reacts to the changed situation, he can buy the assets at a low price with minimal profit.

In all cases, aggressive short selling has a significant effect on the current trends, which requires careful hedging of investment portfolios. Many exchanges have restrictions on naked short sales, in which the seller quickly sells large amounts of stocks he doesn’t own. 

How does this work?

Suppose you want to short Tesla stocks and contact your broker to conduct this transaction. The broker needs to find stock and lend it to you so that you can sell it. He can take it from different places (including his inventory and clients’ portfolios). After that, the broker borrows the stocks and sells them in the market for you.

Let’s say the price falls as expected and you want to close the position and make a profit. You call your broker and ask him to take a buy position. The broker uses the money in your brokerage account to buy a Tesla stock at the current (below original) market price. The difference between a purchase price and a selling price will be your profit or loss.