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Short selling

Short selling stock normally involves selling borrowed securities and buying them back for return. It creates upside, margin, borrow-availability and cost, recall, short-squeeze and jurisdiction-specific rule risks.

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Who this is for — Readers who want to distinguish a sale of owned securities, a short sale of borrowed shares, bearish exposure through derivatives and a “naked” sale.

Short selling a stock generally means selling a security that the seller does not own and that is borrowed so it can be delivered. The position is closed by buying equivalent securities in the market and returning them to the lender. If the repurchase price is below the sale price, the difference is favourable to the short seller before costs; if it is higher, it produces a loss.

In plain language — First the security is borrowed and sold; later it is repurchased and returned. Borrowing, margin and delivery are part of the mechanics, not details separate from the trade.

Economic sequence

  1. The intermediary verifies the availability or locate requirement specified by the market and jurisdiction.
  2. The securities are borrowed or their delivery is arranged.
  3. The sale executes and must settle under the applicable rules.
  4. The position remains subject to margin and to the cost and terms of the loan.
  5. The repurchase (buy to cover) obtains the securities to return and closes the exposure.

Sale proceeds are not the same as freely available capital: the account remains subject to margin rules and the collateral required by the intermediary. The economic result must include commissions, the spread, any slippage, borrowing cost and payments owed to the lender, such as the equivalent of dividends distributed during the loan.

Short sale, bearish position and naked short

Selling a security already owned reduces or closes a long position; it is not a short sale. A bearish position through futures, options, CFDs or other derivatives may have a short payoff without the client borrowing the stock. The contract, counterparty, margin, expiry and settlement differ.

A naked short sale is a sale made without the securities having been borrowed or adequately located for delivery under the relevant framework. The term must not be used as a synonym for every short sale or every failure to deliver. The SEC explains that a fail may result from either long or short sales and does not by itself prove an abusive practice.

Short interest and short volume are also different measures: the first concerns short positions still open on a reporting date; the second counts selling activity classified as short during a period. Neither, in isolation, reconstructs participants' borrowing, hedges or motives.

Specific risks

  • Theoretically unlimited loss: a stock can rise without a predetermined limit, while the maximum gross gain on an equity short is constrained by the fact that its price cannot fall below zero.
  • Margin and forced closure: a price increase may create additional collateral calls or a reduction of the position.
  • Borrow availability: a security may become difficult or expensive to borrow; terms and rates may change.
  • Recall and buy-in: the lender or infrastructure may require return or purchase under the contract and applicable rules.
  • Short squeeze and liquidity: many repurchases in a shallow market can amplify a rise and worsen the covering price.
  • Dividends and corporate actions: the short seller may have to compensate the lender and manage events affecting the security.
  • Regulatory risk: temporary bans, price tests, disclosure obligations and thresholds may change whether the position can be opened or maintained.

A stop-loss does not predetermine the loss: gaps, trading halts, insufficient liquidity and borrow availability can produce an outcome different from the planned level.

United States and European Union

In the United States, Regulation SHO requires orders to be marked long, short or short exempt. The locate requirement generally requires the broker-dealer, before executing a short sale, to have reasonable grounds to believe that the security can be borrowed and delivered by the due date; the rule also imposes close-out requirements for certain failures to deliver. Short sales that comply with the rules are legal; manipulative practices remain prohibited.

In the European Union, the Short Selling Regulation seeks transparency of net positions, reduction of settlement risks associated with uncovered sales and intervention powers in exceptional circumstances. ESMA summarises the prohibition on naked short selling of shares and sovereign debt within the regulation's perimeter, notification and publication obligations above the specified thresholds, and exemptions for certain market-making and primary dealing activities.

The two regimes are not interchangeable. Before describing a position as permitted, covered or subject to disclosure, identify the instrument, venue, issuer, account, intermediary and jurisdiction.

Sources

  • U.S. Securities and Exchange Commission, Key Points About Regulation SHO — short-sale mechanics, borrowing, margin, dividends, loss risk, locate and close-out.
  • U.S. Securities and Exchange Commission, Short Sales — Regulation SHO, Final Rule — marking, locate and treatment of failures to deliver.
  • European Securities and Markets Authority, Short Selling — SSR perimeter, covered positions, transparency, exemptions and intervention powers.
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