Stock Market Guide to Short Selling as a Trading Technique
Short Selling, also known as Selling Short, refers to the common stock trading practice of selling an equity one doesn’t actually own, while intending to buy it back at some future date and - critically - at a lower price. The “short” refers to the trader owing the funds for payment of the equity to their broker, who must be repaid later when the investor succeeds in covering their position. The broker’s role in the exchange is in many ways that of a middleman, since in the vast majority of short selling trades he or she has in turn borrowed the security from another trader who is holding a Long position.
A short seller profits when the security he/she has “shorted” declines in value. The profit is the difference between the lower buy price and the higher, as yet unpaid, sell price. Thus, a trader can profit from an equity whose price falls, as opposed to the more typical arrangement where a stock is bought, rises in value, and is then sold.
In some circles, and historically speaking, short selling is viewed with a measure of disdain because short sellers may be seen as profiting from the misfortune of others. In fact, 18th century English securities regulators banned the practice for that very reason. Short selling was also blamed, unfairly for the most part, of exacerbating the sudden market collapse that deflated the “Tulipmania Bubble” in early 17th century Holland.
In the aftermath of the 1929 Stock Market Crash, American regulators imposed selective bans on short selling, such as forbidding traders from selling their short positions during market down-ticks.
In 1940, mutual funds were dissuaded from short selling, not by stock market regulators but by congressional legislation. Gradually though, short selling was seen as a part of the stock trading system that improved the overall efficiency of the market. By the late 1940s, the first Hedge Funds were established, the name deriving from their trading strategy of buying stocks while engaging in short selling to hedge their market positions and reduce risk.