Being short an asset, in finance terms, is the opposite of being long
an asset. We can define it as:
A short exposure to an underlying means that you make money when the
underlying falls in value, and lose money when it rises in value.
The term "underlying" here is a bit of an umbrella term that can mean
things like stocks, bonds, commodities, or other
This exposure is exactly the opposite of being long. Now, being long
is easy: you just buy the asset. Being short is not nearly as easy: you
normally can't sell something you don't have. Now, it
turns out that in the marvelous world of finance, selling stuff you don't
have is indeed possible. It requires jumping through some hoops and costs
some money, but it is possible. What you for instance can do is the
- I borrow a share from someone.
- I sell the borrowed share for, say, 75 dollars.
- I wait.
- The share price dropped. I buy back the share for 50 dollars.
- I give the share back to the person I borrowed it from.
- I keep the 75 - 50 = 25 dollars.
Now, as you can see, you make money in this trade if the share price
drops, and you lose money when it rises, which is exactly
opposite to buying the share; hence you are short.
This selling stuff you don't own is tricky business at the best of
times, and chances are your broker doesn't allow you to do it unless you
are a big, professional trading firm. For private investors,
derivatives allow you to have a short exposure without having
to short sell the asset.
One way of being short an asset is by selling the call option. A
call option is the right to buy a stock; by selling it, I have the
obligation to sell a stock at a certain level. For this, I get money. Now,
imagine I want to short Microsoft, which at the moment of writing this
trades at 27.06. Imagine I sell the 25 call. This means I am obliged to
sell Microsoft at 25, if my counterparty wants this. It will typically
want this if the share price of Microsoft is above 25. This is bad as I
have to buy it at the current price. So, if it trades at 27.06, I lose 2.06
dollars, but I make the money I got for selling the call.
If Microsoft falls, it's less likely I have to sell Microsoft at a
loss at 25. In fact, if it drops below 25, I might just not have to sell
it at all, and just pocket the money I got for selling the call! Because a
drop in the price of Microsoft stock makes this more likely, I make money
when Microsoft falls. If Microsoft rises, the call increases in value, as I
have to buy back the stock I'm going to have to sell at 25 at an ever
higher price. Hence, I lose money. The net effect is that I lose when
Microsoft rises, and make money when it falls; hence I am short
A second example would be buying a put option. Imagine I buy the 30
put in Microsoft. Buying the put means I get to sell Microsoft at 30. Now,
if Microsoft drops, to say 20, I make 10 dollars, minus what I paid for the
put. The further Microsoft stock falls, the more valuable my put option,
and the more money I make. When Microsoft rises, I have to buy it at a
higher price to be able to sell it for 30, and I make less money. I make
money when Microsoft rises and lose money when Microsoft falls, so I am
Having discussed what a short position is and how to get one, we will
now discuss why we would want to have a short position. It is important to
note that there are few assets that have a price that drops in the long
run. Hence, a short position is usually temporary: funds or investors that profit from systematically going short are rare. Another
disadvantage of short selling is that the price of an asset might rise
to an indefinite value; hence, your potential loss is unlimited. This makes short
selling quite dangerous.
To give an example, imagine you (correctly) predicted that dot-com
stocks in the late 1990s were overvalued. To speculate on this, you short
them. Before crashing, the price triples, bankrupting you in the process.
This is a common danger associated with shorting: The market can stay
irrational longer than you can stay solvent.
The most common reason to go short is in arbitrage trades and in
hedges. I'll give an example of the latter. Imagine I think one oil
company, say Royal Dutch, will perform better than another, say BP.
However, the share price of both Royal Dutch and BP is in principle
strongly dependent on both the general sentiment and the level of the oil
price, both variables I don't know anything about-I only care about the
difference between BP and Royal Dutch. If I short BP and go long Royal
Dutch, I make money when Royal Dutch goes up and BP goes down. If both move
up, my the gain on my long and the loss on my short cancel; if both go
down, the gain on my short and the loss on my long will cancel as well.
This is exactly the exposure I wanted.
Summarizing, being short an asset means that if the asset falls, you
make money. This is used to speculate on a drop in the price of the asset.
It isn't too easy to achieve this for a private investor. One way of
getting a short position is to use derivatives. However, if you are a big
firm, you can just sell an asset you don't have. Going
short can be used just to speculate on a drop in share price, but is also
used in arbitrage trades and as a hedge. This makes the ability to go
short, either by means of short selling or by using derivatives an
important part of the financial market.