A short position is a trading strategy where an investor aims to earn a profit from a falling share price. Investors can borrow shares from a brokerage firm in a margin account and sell them. Then, when the share price drops, they can buy the shares back at the lower price and return them to the broker, earning the difference in share price as profit.
Here’s what you need to know about short positions, how they work, and the risks involved with this investing strategy.
Definition and Examples of Short Positions
A short position is a trading strategy in which an investor aims to earn a profit from the decline in the value of an asset.
Trades can either be long or short, and a short position is the opposite of a long position. In a long position, an investor buys shares with the hopes of earning a profit by selling it later after the price increases.
To create a short position an investor typically sells shares that they have borrowed in a margin account from a brokerage. However, the term short position can also have a broader meaning and refer to any position an investor takes to try to earn a profit from an expected price decline.
How Does a Short Position Work?
The process of creating a short position is called short selling or shorting. In a short sell, an investor first borrows shares of stock from a brokerage firm and sells them to another investor. Later, the investor that borrowed the shares to create the short position must return the shares to the broker they borrowed them from. In order to return the shares, the investor must buy them back.
If the share price declines from the time the investor shorts them until the time the shares are repurchased, then the investor earns a profit.
For example, suppose an investor borrowed 400 shares of stock ABC and sold them short when the price was $45. The share price then drops to $32 and the investor repurchases them to return them to the broker. The investor’s gross profit would be $13 per share ($45 - $32 = $13), minus any commissions or interest on the margin balance.
The total profit earned on the short position is the per-share profit multiplied by the total number of shares that were shorted.
If the brokerage fee in our example is 2% commission on each transaction, we’d calculate the total profit like this:
- The investor borrows and sells 400 shares at $45 for a total of $18,000.
- A 2% fee on $18,000 is $360, leaving the investor with $17,640 after fees.
- The price falls to $32 per share and the investor buys back the 400 shares for $12,800.
- The 2% fee on $12,800 is $256 which leaves the investor with $12,544.
- The investor’s total profit on the short position is $17,640 - $12,544 = $5,096.
Because shorting involves borrowing shares, a short sell must take place in a margin account. You’ll need to ensure the brokerage firm you’re working with allows you to open a margin account before short selling.
While taking a short position is legal, the U.S. Securities and Exchange Commission (SEC) does have some restrictions in place when it comes to who can sell short, which securities can be shorted, and how those securities are shorted.
What Are the Risks of Short Selling?
When an investor takes a short position on an investment, there is no guarantee that the share price will fall. If the share price rises after it is shorted, then the investor will still have to repurchase the shares in order to return them to the brokerage. In this situation the investor will lose on the short position because the shares will be repurchased at a higher price than what they were initially sold for.
To see how that is true, we can just reverse the prices in the previous example. Let’s assume that the investor borrows and shorts the shares when they are initially trading at $32. Then, despite the investors belief that the share price will drop, the share price rises to $45.
We can calculate the loss like this:
- The investor borrows and sells 400 shares at $32 each for a total of $12,800.
- The 2% broker fee on $12,800 is $256 and the investor is left with $12,544.
- The price rises to $45 per share and the investor buys back the 400 shares for $18,000.
- The 2% broker fee on $18,000 is $360, which leaves the investor with $17,640.
- The loss on the transaction is $12,544 - $17,640 = -$5,096.
Another risk of a short sale is a margin call. A margin call occurs when a broker requires that you make a deposit into your investment account because your margin position—the amount you owe the brokerage firm—has become too large.
In a short position, this could happen when the stock's price rises and your equity position in the account has fallen below the required maintenance level. Since a stock's price could theoretically rise indefinitely, there is a risk that your losses would become so great that you could not repurchase the shares to return them to the broker and cover the short position. To reduce this risk, the brokerage firm would require that you deposit additional money or other shares into the account. If you cannot satisfy the margin call then the broker would sell other shares in the account or close the position to avoid greater losses.
In 2010, the SEC adopted what is known as the “alternative uptick rule.” This rule restricts short selling when a security’s share price has already experienced a drop of 10% or more in one day from its previous closing price. The SEC said that this rule is meant to “promote market stability and preserve investor confidence.”
Short vs. Long Positions
|Short Positions||Long Positions|
|Investor sells borrowed shares||Investor buys shares on their own|
|Requires margin||Margin can be used, but is not required|
|Investor profits when the stock price falls||Investor profits when the stock price rises|
What a Short Position Means for Individual Investors
Individual investors that want to try and profit from an expected decline in a share price may do so by taking a short position. However, there is no way to predict share prices with certainty and short selling could result in investment losses if the share price rises after it is sold short. Shorting stock or another security is a more advanced trading strategy. Before taking on a short position, beginner investors should do their research and ensure they’re in the right financial position.
- A short position is created when an investor sells borrowed shares in an effort to make a profit if the share price drops.
- The investor must later repurchase the shares to return them to the brokerage they were borrowed from.
- The investor profits if the share price falls, but loses if the share price rises.
- The investor must have a margin account in order to short sell and could face a margin call if the share price increases.