To sell a security short, an investor, known in this case as a short-seller, borrows the security from a broker and sells it in the open market. In exchange, the short-seller has to post collateral assets in a margin account and return the borrowed stock at a future date by buying the stock back in the open market.
The short-seller pays the broker a fee for borrowing the stock but may earn a rebate on the proceeds from the short sale. The broker usually borrows the shares from another investor, who is holding his shares long. For example, active long investors lend out their securities in order to earn part of a short rebate, the interest on the proceeds from a short sale.
The short-seller is also expected to pay to the lender any dividends that the stock pays. The short-seller hopes that the short position will fall in value, enough to more than of set any cost associated with borrowing the stock.
A short position may be taken in order to hedge, express a relative-value view between two securities or markets, or express an outright negative view on a security. An investor uses a hedging short position to eliminate an undesired risk.
For example, a U.S. investor who likes a foreign stock but does not like the foreign currency may buy the stock and sell short the currency, agreeing to deliver the currency at a future date in exchange for dollars, and thus neutralizing his currency exposure.
Further, when added to a portfolio, short positions reduce systematic risk, as measured by beta, and reduce dependency on cyclical economic factors. For example, equity hedge managers may combine their long holdings with short sales of stock or stock index options to hedge against equity market decline.
An investor uses a relative-value position to capture relative mispricings between two securities by going long a security, which he believes is relatively underpriced and shorting a security with some relationship to the first security, which he believes is over-priced. Relative-value investing is the basis of market-neutral hedge fund investing.
Finally, an outright short position is a method for expressing negative view on a substantially overpriced security. A short position can be expressed not only through cash securities but also with futures and options.
A short position in a futures contract requires the investor to deliver, or sell, a security, at some future date. A short position in a security can also be expressed through options — by selling short a call option or buying a put option.
In the case of a short call option, the seller may be required to sell a security at a prespecified price in the future, and in the case of a put option, the buyer has the option to sell a security in the future.
In addition to risks experienced by long investors, short-sellers are exposed to unique risks such as share availability, "short squeezes", "execution risks", risk of unlimited loss, "taxation", and "legal risks". The number of shares available to borrow for short selling may be very limited, as is often the case with small cap stocks.
When there is a sudden large increase in demand for a stock, short-sellers may be subject to a short squeeze, where they are forced to buy back, or cover, stocks called in by the lenders. When they have to buy back the stock in times of rising prices, short-sellers may suffer significant losses.
Execution risk arises from the "tick" rule, also known as the "uptick" rule, adopted by the Securities and Exchange Commission (SEC) in 1938, which allows a stock to be sold short only at er the price has moved up. This is done to prevent excessive shorting. While there is a campaign to abolish this rule, it currently presents a risk to shortsellers.
Further, short-sellers may experience unlimited losses as prices go higher while their upside is limited. In addition, short sales are taxed at the higher short-term rates and short-sellers are exposed to lawsuits by the companies whose stock they are shorting.
Short-selling improves market efficiency by allowing investors to express negative opinions on securities that are overvalued and to balance a rising market. Short-sellers are usually shorter when the marker goes up, and less short when it falls, acting as a preventive force to market bubbles.