We often refer to positions in our portfolios where we have "sold short", "shorted", or had "short positions" in particular shares. The idea behind short selling of shares is to profit from a fall in the share price of a particular company. How can this be done?

Let's say our analysis shows that XYZ Ltd is overvalued and that we expect the share price to decline. To take advantage of this view we would "short sell" shares of XYZ. To do this we would simply sell the shares of XYZ even though we don't currently own them. The problem we then face is that we must deliver the shares to the buyer. The way we do that is by borrowing the shares from another shareholder of XYZ, who lends them to us for a fee (in the same way a bank would charge you for borrowing money). In the meantime, the proceeds from selling these shares is placed on deposit at money market rates. This interest income accrues to the short seller (ourselves) and depending on the duration of the short position, it would generally pay for the borrowing fee several times over. Naturally any dividends that are declared while the shares are borrowed accrue to the lender of the shares. Assuming we sold a share of XYZ at $20 and it then fell to $14, upon buying them back we would make $6! If instead the share price went up, we would lose money. Once we have bought the shares back we would "return" the stock to the lender and "close" the loop.

The concept of short selling shares is neither new nor unusual, having been around from the day stock markets were first created. In fact most stock markets and countries have rules and laws that specify the manner in which short sales can be made. The major investment banks all run "stock lending" organisations who source the shares from owners who are prepared to lend them (usually the large fund managers) and then on-lend them to the short sellers for a fee. More often than not, when we take a short position in a share, it is in fact done through what is known as a "swap" arrangement with one of these major investment banks. This is effectively a contract between ourselves and the bank that has an identical effect to that of a short sale,but is somewhat more efficient from an administrative perspective, and can lower the transaction costs
of dealing.