13.1 Overview of Short Selling

Most investments involve purchases of assets that you believe will increase in value over time. When you buy an asset you establish a long position in the asset. You profit from the long position by selling the asset in the future at a price higher than the original purchase price. However, sometimes you may believe that an asset will decrease in value over time. To profit on an investment in which the asset price is lower in the future requires short selling the asset. In general, short selling involves selling an asset you borrow from someone else today and repurchasing the asset in the future and returning it to its owner. You profit on the short sale if you repurchase the asset for a lower price than you initially sold it. Because short selling involves borrowing it is a type of leveraged investment and so risk increases with the size of the short position.

In practice, a short sale of an asset works as follows. Suppose you have an investment account at some brokerage firm and you are interested in short selling one share of an individual stock, such as Microsoft, that you do not currently own. Because the brokerage firm has so many clients, one of the clients will own Microsoft. The brokerage firm will allow you to borrow Microsoft, sell it and add the proceeds of the short sale to your investment account. Doing so establishes a short position in Microsoft which is a liability to return the borrowed share sometime in the future. You close the short position in the future by repurchasing one share of Microsoft through the brokerage firm who returns the share to the original owner. However, borrowing is not free. You will have to pay interest on the amount borrowed. You will also need sufficient capital in your account to cover any potential losses from the short sale. In addition, if the price of the short sold asset rises substantially during the short sale period then the brokerage firm may require you to add additional margin capital to your account. If you cannot do this then the brokerage firm will force you to close the short position immediately.