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.