Short selling is the practice of selling borrowed securities or commodities with the intention of buying them back later at a lower price to secure a profit.
Mechanics of short selling
A trader initiates a short position by borrowing shares of an asset from a broker and immediately selling them on the open market. The trader now holds a negative position in that asset and must eventually return the exact number of shares to the lender. The process of buying the shares back to return them to the broker is known as covering the short.
Elephants who engage in short selling generate a profit if the asset’s price falls. They purchase the shares back at the new lower price, return them to the broker, and keep the difference. If the price rises, the trader loses money. They are forced to buy the shares back at a higher price than the initial sale price to close the position.
Unlike buying an asset where the maximum loss is the initial investment, short selling carries theoretically unlimited risk because an asset’s price can rise indefinitely. Borrowing assets also involves paying interest or borrowing fees to the broker. If the trader’s account equity falls below a specific threshold, the broker will issue a margin call requiring the trader to deposit more funds or close the position. Financial regulators across different global jurisdictions enforce strict rules on short selling. Many countries require traders to formally locate borrowable shares before executing a short sale, and regulators occasionally ban short selling entirely during periods of extreme market volatility.
Example
Assume you, as an observant Elephant, notice that a publicly traded agricultural company called Savannah Peanut Corp is facing severe harvest delays. You believe their stock price, which is currently trading at $50 per share, will drop in the near future. You borrow 100 shares of Savannah Peanut Corp from your broker and sell them immediately on the market, generating $5,000 in cash in your account.
Over the following weeks, the harvest delays become public knowledge and the stock price falls to $30 per share. You decide to close your position by buying 100 shares from the open market for $3,000. You return these 100 shares to your broker. You keep the $2,000 difference as profit, minus the borrowing fees charged by your broker. If the stock had unexpectedly risen to $80 per share instead, you would have to spend $8,000 to buy back the shares, which would result in a $3,000 loss.