1. What does it mean to sell something "short?"

2. Why would anyone do that?

1(a). Selling short means selling something, like shares of stock, that you don't own with the promise that you will buy those shares back at a later time. As the seller of something you do not own, you are obligated to borrow those shares so that you can deliver them to the buyer.

2(a). The short seller does this because she thinks that the price of the shares that she is selling, shares she does not own, are going to go down in the future, and she will be able to buy them back--cover her short--a a lower price than what she sold them for. People sell securities of all kinds short when they think the price of those securities is headed down.

Let's look at some examples:

On September 18, 2007 shares of AIG, the insurance company were trading on the New York Stock Exchange (NYSE) at $66.85 per share. Let's say I thought that AIG was in for some tough times ahead and that the price of their stock was going lower. I owned no shares of AIG. What could I do to make some money on the decline in its stock price? Sell the shares short!

So on September 18, 2007, I sold 1000 shares of AIG short at $66.85, shares which I did not own. I received $66,850 for my sale.My broker made the appropriate arrangements for me to borrow those shares that I did not have.

On September 18, 2008, one year later, I decided to "cover" my short by buying 1000 shares on AIG on the NYSE, where AIG still trades. I discover that a share of AIG is now trading at $2.69. I buy 1000 at that price, costing me $2,690, thereby fulfilling my promise to purchase the shares at a later time.

So how did I make-out on this transaction? Well, I got $66,850 when I sold AIG short, and paid $2,690 a year later when I "covered" the short. $66,850 - $2,690 = $64,160, my gross profit on the trade.

The stock went to hell, but I went to heaven. [The example of AIG uses the actual numbers and dates of the stock's trading on the NYSE.]

During that same time-frame, for examples, Washington Mutual stack went from $37.74 down to $2.99, Morgan Stanley, from $68.51 to $22.55 , and final example, Fannie Mae stock went from $62.54 to 49 cents!

Short selling can and is done with oil as well. People who sold oil contracts short at $147/barrel in July of 2008 could have covered their shorts at $91/barrel a couple of days ago, for example.

Yes, there's tons of money to be made when markets go down, if they go down.

The risk with selling short is this: In the example above of Fannie Mae, if you had bought the stock at $62.54 and held it all the way down to virtually zero, you would have lost $62.54 per share---that was the maximum you could ever lose. But when you sell a stock short, there is no theoretical maximum to how much money you can lose.

For example, you decide to sell stock XYZ short at $20/share. But instead of going down, it rises. To $22, then $29...a week later it's at $34.50, a month later at $50. You SOLD it already at $20, and agreed to buy it back at some point to cover your "open" short position. At $50, you have already lost $30 per share. What if it goes to $100 or $150....? There is no ceiling on how much money you can lose if you are wrong on a short sale.

That's why playing the short side is not for the feint of heart.

Update 9/19/08: The Securties and Exchange Commission today announced a ban on short selling of the stock of 799 financial institutions. The ban will be in effect until at least 10/02/08.

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