Short selling is the selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
An investor that is bearish on European economies can make money by "shorting", for example, the euro.
Such an investor can borrow, say, 10,000 euros today and promise to return to the lender 10,500 euros one year from now. The investor who borrows these euros can then sell them for, say, dollars. If the euro-dollar exchange rate is one-to-one -- that is, if today each euro is priced at $1 -- then the investor receives $10,000 in exchange for the 10,000 euros.
If this investor's pessimism about Europe's economy proves correct, the value of the euro will fall significantly during the coming year, enabling this investor to earn a profit on his correct assessment.
Let's say the price of a euro falls over the course of the year from $1 to 50 cents. This investor can repurchase the euros he'll use to repay his debt for a total of $5,250 - which is what 10,500 euros cost at a price of 50 cents each.
The investor profits to the tune of $4,750 -- the difference between the $10,000 that he received when he sold 10,000 euros one year ago and the $5,250 that he must spend today to repay his euro debt.
Role of short selling
Short selling makes an important contribution to the market by:
- Adding liquidity to share transactions. The additional buying and selling reduces the difference between the price at which shares can be bought and sold.
- Driving down overpriced securities by lowering the cost to execute a trade
- Increasing the overall efficiency of the markets by quickening price adjustments
- Acting as the first line of defense against financial fraud. For instance, in 2001, famed short seller James Chanos identified fraudulent accounting practices that occurred with the Enron Corporation, an energy-trading and utilities company. The company's activity became known as the Enron scandal when the company was found to have inflated its revenues. It filed Chapter 11 bankruptcy at the end of 2001.
- "Short Selling Definition", Investopedia, referenced 2011-11-16.
- Donald J. Boudreaux. "Who you callin' 'Shorty'?", Pittsburgh Tribune-Review, May 27, 2010. Referenced 2011-11-16.
- "Short Selling: Ethics And The Role Of Short Selling", Investopedia, referenced 2011-11-16.
- The Function of the Short Seller by Gregory Bresiger, September 2003
- Do Short Sellers Convey Information About Changes in Fundamentals or Risk? (pdf) by Jennifer Francis, Mohan Venkatachalam and Yun Zhang, September 2005
- Don't Sell Short Selling Short by Gary Galles, April 2007
- Short-Sale Restrictions Are an Exercise in Naked Power by Robert P. Murphy, August 2008
- The SEC Short Sells Us Down the River by Art Carden and Robert P. Murphy, October 2008
- SEC chief has regrets over short-selling ban by Rachelle Younglai, December 2008
- Short Selling: Explanation and Defense (audio) by Art Carden, August 2009
- We Call Upon the Hedge Funds by Dan O'Connor, September 2009
- Short Selling: The Risks, Investopedia, by Brigitte Yuille
- Short (finance) at Wikipedia