A person is said to have a short position when he sells the asset that he does not own. This is equivalent to writing and selling a contract. A short position holder benefits when the price of the asset falls. Typically, a short seller will short sell at a higher price and wait for the price to fall and then repurchase the asset at a lower price to close his position.
Short selling is also useful as a hedging tool. Let’s take an example of a manufacturer who holds a large inventory of aluminium. The risk for him is that the price of aluminium may fall. He can protect himself by selling aluminium futures short. If the price of aluminium falls, then he will lose money on the value of inventory, but will gain from his short position.
Since a short seller does not own the security that he is selling, he does so by borrowing the security from a security lender who has a long position in the security. The short seller borrows the security and sells it to other traders. To close the position he will repurchase the security and return it to the security lender. The profit potential in a short sale is limited with a cap equal to the price at which the security was short sold. The losses can be unlimited as the short seller loses money when the stock price appreciates.
When a security lender lends the security, he does not technically own the security for the period of the loan. Therefore, to protect his interest, he enters into a detailed agreement with the borrower that specifies the terms. This includes things such as the following: 1) The borrower should pass on any dividends or interest received on the security during the period of the loan to the lender. This is called payment in-lieu of dividends. 2) The lender should be protected from a stock split. 3) The short seller is required to keep the proceeds from the short sale with the lender as collateral. The lender can invest this deposit in short-term securities. The interest is rebated to the short sellers at short rebate rates (usually 10 bps less than overnight rate in interbank funds market).
