What Is a Short Position (Short)?
Defined and Illustrated Short Positions
Using the short position trading method, an investor seeks to profit from the asset's value drop.
A short position is the polar opposite of a long position in a trade, which can be either long or short. In a long position, an investor purchases shares in the anticipation of subsequently selling them for a profit when the price rises.
An investor often sells shares they have borrowed in a margin account from a brokerage to establish a short position. However, the phrase "short position" can also be used in a more general sense to describe any position a trader takes in an effort to profit on an anticipated price fall.
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How Do Short Positions Operate?
Short selling, often known as shorting, is the act of opening a short position. A short sale involves an investor borrowing stock from a brokerage house, then selling it to another investor. The investor who borrowed the shares to open the short position will later have to repay them to the broker. The investor must repurchase the shares in order to return them.
The investor will profit if the share price falls from the time the shares are shorted to the time they are bought back.
Assume, for instance, that a stockholder borrowed 400 shares of ABC and sold them short at a price of $45. When the share price reaches $32, the investor buys more shares to sell back to the broker. The investor's gross profit, less any commissions or interest on the margin balance, would be $13 per share ($45 - $32 = $13).
The per-share profit is multiplied by the overall number of shares that were shorted to get the total profit made on the short position.
In our example, if the brokerage cost is 2% of each transaction, we would determine the overall profit as follows:
For a total of $18,000, the investor borrows and sells 400 shares at a price of $45.
After fees, the investor will get $17,640 after paying a 2% fee on $18,000, which comes to $360.
The investor purchases the 400 shares back for $12,800 when the price drops to $32 a share.
The investor is left with $12,544 after deducting the $256 2% fee from the $12,800.
The investor made a total profit of $5,096 on the short position of $17,640 minus $12,544.
Even though it is lawful to hold a short position, the Securities and Exchange Commission (SEC) of the United States does have some limits on who is allowed to sell short, which securities are allowed to be sold short, and how those securities are shorted. 2
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What Risks Are Involved in Short Selling?
loss on investments
There is no assurance that the share price will decline when an investor takes a short position on a security. The investor will still need to repurchase the shares in order to sell them back to the brokerage even if the share price increases after being shorted. As a result of the shares being repurchased at a price greater than what they were originally sold for, the investor in this case will lose money on the short position.
We only need to flip the pricing in the preceding example to see how that is accurate. Assume that the stock is borrowed and sold short when it first trades at $32 a share. The share price then increases to $45, defying the expectations of the investors that it will decline.
The loss can be calculated as follows:
For a total of $12,800, the investor borrows and sells 400 shares at a price of $32.
The investor is left with $12,544 after deducting the $256 2% broker fee from the $12,800.
When the share price reaches $45 per share, the investor pays $18,000 to purchase the 400 shares back.
The investor is left with $17,640 after deducting the $360 2% broker fee from $18,000.
The transaction has a loss of $12,544 - $17,640, or -$5,096.
Edge Call
Margin calls are yet another danger of a short sale. A margin call happens when a broker requests a deposit into your investment account because the amount you owe the brokerage company for your margin position has grown too large.
This could occur in a short position if the stock price increases and your equity holding in the account drops below the necessary maintenance level. There is a chance that your losses might grow so large that you would be unable to buy the shares back to cover the short position and return them to the broker because a stock's price could theoretically increase eternally. The brokerage house would demand that you contribute more funds or extra shares to the account in order to lower this risk.
In order to prevent further losses, the broker will terminate the position or sell additional shares in the account if you are unable to meet the margin call.
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Positions: Short vs. Long
Limited Positions
Extended Positions
An investor sells shares he borrowed.
A self-directed investor purchases shares and needs margin
Margin is optional but may be used.
When the stock price declines, investors profit.
When stock prices increase, investors make money.
The Implications of a Short Position for Individual Investors
By taking a short position, individual investors might attempt to profit on an anticipated decrease in a share price. Short selling could result in investment losses if the share price increases after it is sold short, as it is impossible to predict share prices with accuracy. A more complex trading tactic is to short a stock or other security. Beginner investors should conduct research and make sure they are in a sound financial position before taking on a short position.
Main Points
When a shareholder sells borrowed shares in an effort to profit from a decline in the share price, they are creating a short position.
The shares must be later purchased by the investor in order to return them to the brokerage from which they were borrowed.
Investors gain when share prices decline but lose when share prices increase.
To short sell, an investor needs a margin account, and if the share price rises, they may get a margin call.
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