Short Selling – Explained for Dummies

What is short selling?

Simply put, short selling is a trading strategy utilized by traders, aiming to profit from a possible decrease in the price of a security.

Short selling is also referred to as ‘shorting’, ‘going short’, ‘shorting stock’ or ‘selling short’. The terms ‘sell’ and ‘short’ are frequently interchangeably used by day traders.

Short selling mostly occurs on stock trading, although it is a strategy that is used in various other financial markets, such as foreign exchange (forex), indices, derivatives, exchange traded funds (ETFs), bonds, commodity futures, and cryptocurrencies.

The origin of short selling and some financial crises caused by selling short

Short selling has been practised since the early 1600s with the emerging of stock markets in the then Dutch Republic. Apparently, Isaac le Maire, a Dutch businessman and considerable shareholder of the Dutch East India Company, started the practice of selling short in 1609. When the Dutch stock market crashed in 1610, Le Maire was blamed for the crisis.

Jacob Little, the ‘Great Bear of Wall Street’, began to short sell stocks in the U.S.A. in 1822.

Short sellers were condemned for the Wall Street Crash in 1929, and critics argued that short selling contributed to a large extent to the financial crisis of 2008.

How does short selling work?

The features of short selling an asset, such as shares of a stock, are:

• A trader (usually a day trader) opens a short position by borrowing the shares from a broker dealer (trader).

The shares borrowed are from the broker’s own pool or are those that are in safekeeping on behalf of clients.

Typically, there are two types of loans with regard to securities borrowed from a broker:

• Call loans are the most common type of loan and can be terminated by the lender (broker) at any time.
• Term loans that are provided for a certain period, for example, one month.

This implies that the trader does not actually own the shares he or she is trading.

• The trader then immediately sells the borrowed shares at the current market price.
• To close a short position, the trader purchases the shares back at a lower price on the market and returns them to the broker.
• To open a short position, a trader is required to have a margin account with the broker who lends the shares. The margin account must maintain a certain value, known as the maintenance margin.
• There are certain costs involved in short selling, such as a lender’s fee, the interest charged by the broker on the value of the borrowed shares while the position is open, and commissions charged on trades.
• The main aim of selling short is to gain a profit, generated by the difference between the initial sale price of the shares and the price to purchase them back, less the costs pertaining to the short sale.
• However, if the price of the borrowed shares does not fall as expected, but rises, the trader is obliged to buy back the shares at an increased price and incurs a loss.

Examples of short selling

Profitable short selling

• Let us assume the shares of company KDT currently trade at R30 per share.
• A trader borrows 200 KDT shares from a broker and sells them short for the amount of R6 000 (200 x R30).
• After a certain period, the shares decline to R25 per share, and the trader decides to re-purchase the shares for R5 000 (200 x R25) and returns them to the broker.
• The profit on the short trade would be R1 000 (R6 000 – R5 000), minus any commissions and interest payable on the shares borrowed.

Loss-making short selling

• Let us say a trader borrows 200 KDT shares valued at R30 per share and sells them immediately for R6 000 (200 x R30).
• However, instead of an expected decrease in the share price, it jumps to R45 per share. To close the short position the trader is required to buy the 200 shares back at R45 per share for R9 000 (200 x R45) and return the shares to the lender.
• In this case, the loss would be R3 000 (R9 000 – R6 000) added to any costs, such as interest on the borrowed shares and commissions.

Reasons for short selling

Usually, traders execute short selling as part of a speculation strategy, intending to generate profits from the falling prices of securities.

Traders or investors who are more risk-averse may utilize short selling as part of a hedging strategy. Such traders are going short on a security to counterbalance some of the risks pertaining to a long position. For example, assuming that the price of a security will increase, the price declines instead. In such a case their gains from their short positions reduce their losses on their long positions. However, this can be an expensive strategy.

Some methods of going short

There are various methods to execute short selling, such as:

• ‘Physical’ short selling, as described above under, ‘How does short selling work?’
• Short positions can also be enacted via common derivatives, such as options, futures contracts, and forward contracts, in which a trader can assume an obligation or right to sell an underlying asset at a predetermined date in the future at a predefined price.

If the price of the underlying asset drops below the specified price, then the asset can be purchased at the lower price and immediately thereafter being sold at the higher price as defined in the specific derivative contract.

• Short positions achieved through contracts for differences (CFDs), stating that if the closing trade price of an underlying asset is higher than the opening price, then the seller will pay the buyer the difference, reflecting the buyer’s profit. Contrarily, if the asset’s price falls below the opening price, the seller will benefit and will have a short position.

Some advantages of short selling

• Benefitting from a decrease in the value of a security without owning it.
• Trading can be checked and controlled by utilizing different market orders and stop-loss orders.
• The possibility of high profits. However, keep in mind, high profits imply high risks.
• Leverage can be employed, enabling a trader to open positions larger than his or her capital allows.
• Can be used to hedge other trades or investments.

Some disadvantages of selling short

• The major disadvantage or risk of short selling is to incur infinite losses. If the security’s price does not go the way you expected it would go, your losses could potentially be unlimited because there is no upper limit to a stock’s price.
• A margin account is required, subjected to certain terms.
• Interest on borrowed securities.
• Short squeezes can occur, meaning that short sellers are forced to buy increasing security in order to prevent even greater losses, adding upward pressure on the security’s price.

Is short selling legal?

Yes, it remains legal in most financial markets, barring so-called naked short selling, meaning going short without first borrowing the shares.

Although, some governments and financial regulators do sometimes impose certain restrictions on short trades in order to reduce volatility and chaos in financial markets during world and financial crises, such as the financial crisis in 2008 and the Covid-19 pandemic in 2025.

Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.