Having a short position in a stock means that the investor is expecting to make money from the decline in price of a stock. It is the opposite of a long position.
"Normal" investing is buying shares of a company, holding them as the company does well and watching the share price go up, possibly getting some dividends along the way. This investor makes money when things go well for the company and/or the economy. This is right, proper, and the red-blooded American way of investing. This way of investing is called "going long" (not to be confused with the directions of your pickup football game's quarterback, "going deep").
People who invest "short," on the other hand, are viewed as being against America, capitalism, and, quite possibly, apple pie. They make money when the company messes up, loses money, or otherwise sees its share price decline. Definitely anti-American, at least according to some.
One common use of a short position is as a "hedge" to offset some risk. For instance, if an investor is long in one stock of an industry, that investor might go short in another company of the same industry to protect against losses in the first company if the industry as a whole declines. The losses in the long position would be offset by gains in the short position.
In order to go short, the investor borrows shares from another ("normal") investor, sells them to somebody else, and then purchases them back at some future point in time, returning them to the original owner. When it works, it still follows the "buy low, sell high" mantra, but it does the selling first, then the buying.
Both the short seller and the one whose shares are borrowed must be using a margin account.
In the past, the exchange required an uptick in the price of the stock (that is, the last trade must have been higher than the previous trade) before shares could be sold short.
While the short position is open, the person doing the shorting must pay the person lending the shares any dividends paid. This can be a disadvantage.
The maximum gain to be made is 100% of the original investment, which only happens if the stock falls all the way to zero. The maximum loss is infinite, as the stock price can continue to rise. Note that this is the opposite result of what long investors expect. Most brokers impose a limit on losses and require the short investor to "close" their position by repurchasing the shares after a certain amount of price rise. If many people are short the stock when the price rises dramatically, this forced closure of their positions can create a short squeeze.
Even though many people look down (or even hate) short investors, these investors play an important role in the market. When a stock price has grown too fast or too far, such that the company's performance cannot support the price, an increase in short positions will tend to drive the price down, restoring some balance to the market. It's been hypothesized that one reason the stock market "dot-com" bubble of the late 1990s, early 2000s got so out of hand is that there were not enough short investors helping to hold prices down at more reasonable levels.
Possibly because of this misunderstanding about the role of shorts (besides being comfortable clothing), that is a belief that the shorts are driving down the price of a company's stock, the SEC banned the shorting of financial (primarily bank) stocks in the fall of 2008 to give protection to these companies against the downward pressure short selling is said to create. Of course, if a company, such as a bank, is losing money for its shareholders, nothing any regulating body can do can prevent the decline of the stock price -- people can still sell their long positions, which will also lower the price -- so that move was really kind of silly.
Motley Fool jobrfool: Brokers may or may not generally charge interest on short sale positions. Some brokers may pay interest to the account that has loaned substantial amounts of shares for short sales. See http://answers.yahoo.com/question/index?qid=20080228180413AA9Ko4a
Related Fool Articles
- Bear market
- Margin account
- Rule 3b-3: Definition of a short sale
- Short squeeze
- Short interest