Many investors get confused by the concept of short selling, but it is really very simple. The goal of securities trading is to buy low and sell high. The typical method used to accomplish this goal is to buy a security and then sell it at a later date, hopefully at a higher price. The difference between the price paid when purchased and the price received when sold equals the profit or loss on the transaction. Short selling simply reverses this process by allowing the sale to come first and the purchase to come at a later date. The goal of buying low and selling high is the same, the timing is just reversed.

The bottom line of short selling is figured in the same way, i.e.: a gain is realized if the security is purchased for less than it was originally sold for and a loss is incurred if the purchase price is greater than the sale price.

Someone purchases a stock because they believe that a company has good growth prospects, above average management, an advantage on the competition, is undervalued, or for some similar reason. Selling a security short is done for the exact opposite reasons that securities are bought (long).

Stated another way, the short seller sells a security that he believes will fall in value and then waits for the price to fall. If all goes as planned, he later buys the security back (covers the short) at a lower price and thus closes out (or covers) his short position at a profit. Thus, a short sale is simply a vehicle for making trading profits on the decline in the market value of a security, selling at a high price and later buying at a lower price.


ABC stock is selling at $20 per share, and an investor believes that the price is too high and the stock will soon fall, so he decides to sell ABC short. He calls his broker and arranges to borrow 1000 shares of the stock, then he sells the 1000 shares short @ $20, receiving $20,000 in proceeds from the sale. He now has the money (held in his account as security) and owes 1000 shares to the lender.

Suppose the investor was right and the stock declines to $10 per share and the investor buys the stock ("buys to cover") for $10,000 and delivers it to the lender. The final tally for this investment is:

Short sale proceeds	$20,000
Less: buy-back purchase	($10,000)
Profit on trade	$10,000

Now, suppose that the investor was wrong, and the stock increases to $30 per share before he decides to cut his losses and buys 1000 shares to cover his short position. In this scenario the results of the trade would be:

Short sale proceeds	$20,000
Less: buy-back purchase	($30,000)
Loss on trade	($10,000)

Whenever a broker enters a sell order of any kind, he must designate the sale as either a long or a short sale. The official definitions of short sales are found in SEC Rule 3b-31, but a short sale generally occurs where the seller is not long the security being sold or does not intend to deliver an existing long position by settlement date.

In addition to outright owning the security being sold, an investor is also considered to be long a security if one or more of the following conditions are true:

• he owns a security convertible into the security being sold and has tendered the security for conversion; or


• he has an option to purchase the security and has exercised the option.