How Short Selling Works

I have had a number of people write to me over the last few days asking how exactly short selling works and whether I can provide an example. This is a great question and often confuses many traders and investors alike in the market. The primary reason for this is the logic behind selling and buying the shares. When most people think about short selling they think about taking a ‘short position’ – that is , a position where they believe the shares are going to fall – but they aren’t 100% sure of how the actual process works. A few people seem to be confusing short selling with the logic of “put options” – and in reality they are very different.

Short selling is effectively – selling what you don’t own – to engage in short selling you need to find a person who owns shares and believes that the share is going to rise. In undertaking short selling, you do think that the price is going to fall. You are effectively “betting against” people who think its going to rise.

The following example should help to illustrate (please note that are differences between naked short selling and covered short selling which are explained in the link at the bottom of this post) :

1. Fred approaches his stock broker and says “I want to short sell NAB at current market rate of $20″
2. The stock broker would approach a large investor who has gone “long” on NAB shares and thinks they are going to rise (i.e. the large investor holds a bunch of NAB shares and thinks that they are going to rise)
3. The stock broker effectively “borrows” these shares from this investor and sells them at the current market rate – deriving a cash sum. The broker is now indebted to the investor for X  number of shares and holds cash for Fred.
4. The stock then falls to $18 and Fred wants to cash out and tells his broker.
5. The broker then uses the money from the sale of the shares “borrowed” from the large investor, and buys them at a rate of $18.
6. This costs $18 per share and the stock broker then gives the large investor the number of shares borrowed.
7. Fred has made $2 and pays a premium to the stock broker, who would have in turn been charged a premium from the large investor.

So a proper illustrate in a practical sense:

1. Fred “borrows” 1000 shares at $20 and immediately sells them at market price earning $20,000
2. Stock falls to $18
3. Fred buys 1000 shares at $18K
4. Fred “returns” the “borrowed” shares to the “borrower”
5. Fred keeps $2K profit
6. Fred’s $2K has a “premium borrowing” charge of 10% – so he has to pay this for “borrowing” the shares – $200 to the company.
7. Fred Nets $2K – $200 = $1,800

Obviously, you have to find an investor who is willing to “lend” the shares. Most big investors buy shares to go “long” not short – so many are “hesitant” to do this. However, the reason they do is that you have to pay a “premium” for “borrowing the shares”. Of course, the rationale is that big investors are in for the “long haul” and short selling is really just to gain from “short term” news. To learn more about short selling and the current affects on the ASX – read this article.