Ask Professor Milligan: What is a Short Sale?

What is a Short Sale? In this episode of Ask The Professor, Professor Milligan answers the question: What is a Short Sale? Gamestop and AMC Theatres are reviewed.

A short sale in the context of the stock market is a trading strategy that involves selling a security that the seller does not own at the time of the sale. Traders use this strategy when they anticipate that the price of the security will decline in the future, allowing them to buy it back at a lower price and profit from the difference. Here’s how the process typically works:

Borrowing the Shares: The trader borrows shares of the stock they wish to short sell from a broker. This requires having a margin account, as short selling involves borrowing.

Selling the Borrowed Shares: Once the shares are borrowed, the trader sells them on the open market at the current market price.

Buying the Shares Back: The trader hopes that the price of the shares will decline after they have sold them. If the price drops, they can buy back the same number of shares at the lower price.

Returning the Shares: After buying back the shares, the trader returns them to the lender (which is typically the brokerage firm from which they were borrowed). The difference between the sell price and the buyback price is the trader’s profit (minus any fees and interest charged by the broker for the loan of the shares).

Risks: Short selling comes with significant risks. If the price of the stock rises instead of falling, the trader will have to buy back the shares at a higher price, leading to a loss. There’s theoretically no limit to how high a stock price can go, which means there’s no limit to the potential loss on a short sale, making it riskier than buying stocks (where the maximum loss is the initial investment).

Short sales are subject to regulation and require careful monitoring because of their potential to cause rapid price declines in a stock. For instance, regulatory bodies may impose “uptick rules” that restrict short selling to conditions where the last sale price was higher than the previous price, aiming to prevent the acceleration of a stock’s decline.

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