Short Sales - Concept

Concept

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 equivalent securities and returns them to the lender. The process relies on the fact that the securities (or the other assets being sold short) are fungible; the term "borrowing" is therefore used in the sense of borrowing $10, where a different $10 note can be returned to the lender (as opposed to borrowing a car, where the same car must be returned).

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 will usually hold 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.

The act of buying back the securities that were sold short is called "covering the short" or "covering the position". 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 will not be affected by any subsequent rises or falls in the price of the securities, as he already holds the securities required to repay the lender.

Short selling refers broadly to any transaction used by an investor to profit from the decline in price of a borrowed asset or financial instrument. However some short positions, for example those undertaken by means of derivatives contracts, are not technically short sales because no underlying asset is actually delivered upon the initiation of the position. Derivatives contracts include futures, options, and swaps.