Short sale

A short sale is an operation in the  financial market where a speculator exchanges shares or other securities that are not owned by him.

The transaction consists of the investor borrowing several units of a financial security , selling them and then repurchasing them, ideally at a lower price to obtain benefits. Finally, the instruments return to the hands of the one who lent them.

A short sale is also called a short position .

Short Selling Features

Among the characteristics of the short sale are:

  • The speculator expects a decrease in the price of the financial asset. Only if that happens, you get a return.
  • The profit from the operation is the difference between the sale amount and the repurchase amount. In addition, transaction costs (administrative costs charged by the broker) must be discounted.
  • Usually it is the brokerwho lends the financial securities.
  • If the stock goes up, the speculator could be forced to pay a higher price than the one received for the sale. Another alternative would be to wait for the price to drop to buy back the securities and return them to their rightful owner.
  • Taking into account that there is no ceiling to the price of a share, the maximum losses for this type of operation are incalculable. However, a very out of the ordinary and unexpected event would have to occur for the price of an asset to skyrocket in the short term.
  • The maximum return on a short sale is approximately 100%, if the share price falls close to zero. In this scenario, the investor should spend almost nothing on the repurchase of the securities.
  • By carrying out this operation, the investor is opting for a short position, that is, he seeks to sell expensive and then buy cheap.

Example of short sale

Let’s look at an example of short selling. Suppose that the market anticipates a drop in the shares of Minera XZ due to a drop in the price of metals internationally. With this information, Luis González contacts his broker to borrow 100 titles from the aforementioned company.

The price of each share is US $ 50. González makes the corresponding short sale for a total of US $ 5,000 (50 x 100).

The next day, let’s imagine that the share price fell to US $ 47. Therefore, the investor can buy back the securities for US $ 4,700 (47 x 100).

If the transaction costs are US $ 30, the profit of the operation would be as follows:
100 x (50-47) – 30 = US $ 270

Now let’s analyze two extreme situations. On the one hand, if an extraordinary negative event happened and the stock fell to US $ 1, the profit of the speculator would be greater than in the previous scenario:

100 x (50-1) – 20 = US $ 470

On the other hand, the price of the security could rise, for example, to US $ 60. In this context, the investor may be scared and decide to buy back the securities before their price continues to rise, disbursing US $ 6,000 (60 x 100) . Thus, the operation would record the following loss:

100 x (50-60) – 30 = -US $ 1,030

 

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