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: 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?
Investment Losses
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:
Margin Call
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.
