A short sale occurs when someone borrows a security (or a futures contract) from a broker and sells it, with the understanding that he will later buy it back (hopefully at a lower price) and return it to the broker. Investors use short selling (or "selling short") to try to profit from the falling price of a stock.
For example, if an investor believes stock x is overpriced and will fall, he might want to sell short 100 shares of x. His broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price. If the price drops, he "covers" the short position by buying back the shares, and his broker returns them to the lender.
The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. If the price goes up, however, the potential for loss is unlimited, because at some point the investor must replace the 100 shares of x he sold.
Short sellers are in the minority, making up on average less than 5 percent of positions on the New York Stock Exchange.
- "Short Selling: Nasty, Brutish and Short". The Economist.