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The Short in a Nutshell
The simplest explanation of shorts you’ll read today.
At its most basic essence, selling short is selling an IOU note. There are several variations on how a “short sale” works, but at the end of the transaction, here’s the situation:
- The short seller has cash.
- The short seller owes someone else one or more shares of a specific stock.
That’s it. From the perspective of the short seller, they have effectively sold an IOU (“I owe you”) note denominated in shares of a specific stock. This is true for both “naked” shorts and “covered” shorts. After the initial short sale, the short seller has the same type of asset gained (cash) and the same obligation (delivery of a share of stock to someone else by a given deadline).
The difference between the two is that in a naked short, the person who paid cash is also the one holding the IOU. The requirement to “borrow” a share theoretically curbs the worst abuses of short selling, because it slows down the process of selling shorts. However, as seen in the diagram below, once the short seller sells the short, they’re in the same risky position until they close the short sale by buying stock.
Unless the short seller owns the stock, the risk attached to this is theoretically unlimited, which makes short sales potentially dangerous. For example, if someone shorted $10,000 of Nortel stock at a short price of $4 per share in September 2002 just before it bounced up to $12 per share, they would have had to pay out $30,000 buying Nortel stock for other people.
A short mainly a tool for speculation, rather than investment. For people who own a stock and expect the stock to drop in value, it’s easy to simply sell the stock immediately. For shareholders who want to hedge against risk, there are other options, particularly a put (the right to sell a particular stock at a given price).
Weird Market Dynamics With Short Sales
There are two major ways that short sales can drive major movements in the stock price of a company that…
