What is a Short Sale?

//What is a Short Sale?
What is a Short Sale? 2017-10-10T06:45:29+00:00

Definition: A short sale typically has two meanings. In real estate, it means selling a house for less than the outstanding mortgage. In investing, a short sale is a strategy in which an investor takes a short position in borrowed shares, expecting the market price to decline before maturity to realize a profit.

What Does Short Sale Mean?

What is the definition of short sale? In essences, it’s selling something for less than you owe on the property. It doesn’t matter whether its real estate or stocks, but I’m going to focus on investment selling because it’s more complicated.

Short-selling is a risky strategy, mostly used by experienced investors, with the aim to hedge the downside risk of a long position. A short seller has the right to buy the borrowed shares and return them to the broker before maturity to get protected from potential fluctuations of the stock market.

Normally, brokers borrow the shares from fund management firms and institutional investors. A short-sale is successful if the price of the underlying security declines. Therefore, an investor that uses short-selling believes more in a bearish rather than in a bullish market.

Let’s look at an example.

Example

Elliot has 500 shares of a pharmaceutical company that trade at $89. His broker confided in him that the company is about to release mixed results in the coming quarter with a drop in total revenues of 5%. Therefore, Elliott decides to enter a short-sale contract by borrowing 200 shares from his broker and selling them for a total of 200 x $89 = $17,800.

Following the firm’s quarterly results, the stock price declines to $84.20. Elliott decides to exercise his short sale and buy 200 shares at $86.20 for a total of 200 x $84.20 = $16,840.

He returns the borrowed securities to his broker, and he realizes a profit of $17,800 – $16,840 = $960 minus borrowing fees and broker commission.

If the stock price hadn’t declined to $84.20, but, instead, had risen to $92.30, Elliot would have to return the 200 shares to his broker for a higher price that he had sold them originally. In this case, Elliott would lose (200 x $89) – (200 x $92.30) = -$840 plus the borrowing fees and broker commission.

Summary Definition

Define Short Sale: A short sale is when a piece of property is sold for less than the amount owed on it.