Also known as short selling
, is the practice of selling a security
that the investor does not
This curious practice is intended to allow the astutue investor to profit
on the depreciation
in price of a companys stock price
It works as follows :
Consider a programmer
who suspects that IBM's shares are wildly over valued
. Note that she does not own
any IBM stock at all.
IBM shares, or sells them at the current market price
, say $100 a share. She receives $100 in cash
for every share she sold. She can do whatever
she likes with this cash
, since it is her money from this point on.
Meanwhile, on the other side
of the transaction
has bought the IBM shares that she sold.
To deliver these securities
to the purchaser
, her brokerage
firm will borrow
IBM stock from the dormant
holdings of an institutional investor
Institutional investors are defined as the large pension
and mutual funds
, who typically will buy and hold
shares for long periods of time. By participating in short selling
this class of investor is able to earn additional fees
from their shares.
Note that the programmer has effectively borrowed something - in this case, IBM stock - and sold it. For this privledge
she must, of course, compensate the real owner.
She pays interest
to the institutional investor in the form of a small fee, which is known as the broker call rate
, however, she must close out the position
and return what she has borrowed
. To do this, she must acquire IBM shares in the open market
To complete this example, assume that IBM sharply drops to $30 a share. The lucky programmer purchases it at this price, and repays her loan from the institional investor; this is called closing out a short position
The difference, $100 - $30 = $70 is her gross profit
per share sold.
She must also, of course, include any interest and brokerage fees that she paid to determine her net profit
is clearly a very risky
trading strategy. If IBM had gone to $200 a share, the programmer would have lost
$200 - $100 = $100 A SHARE