What is short selling?

Justin Ling Updated by Justin Ling

When you short-sell securities you are effectively borrowing the security from someone else so that you can sell it today. When you "cover short" you pay back the security.

Why do this?

You would do this because you believe the selling price of the security (today) is attractive, and that in the price will be lower than it is today. Short-selling enables you to take advantage of this by borrowing to sell something you do not own.

Rudimentary Example:

Mike, Jim and Lily are market participants.

Mike wants to buy Tesla stock at $420 (this is the current bid for Tesla).

Jim thinks selling here would be profitable, but he does not own any Tesla.

Lily owns 1 share of Tesla but thinks Tesla is a great investment and would not sell it at this price.

Short-selling allows Jim to borrow the 1 share of Tesla from Lily to sell it to Mike today at $420. Jim now gains +$420 from the sale, but now owns minus 1 share of Tesla (the share he owes Lily).

In the future, if Tesla's price decreases below $420 Jim can buy the share back and repay Lily, generating a profit. But if the share increases in price, he'll be on the hook to repay her the share at the higher price and create a loss.

Limits to Short Selling / Margin

As Short selling is borrowing, brokerages put a limit as to how much you can short sell, to ensure you are able to pay back what you have borrowed (even if things go sideways).

At EquitySim the Margin or Borrowing limit is 50% of the value of your account.

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