How Short Selling Works

Short selling is often looked at as a nefarious aspect of trading and investing. However, it is quite legal, serves a necessary function in the securities markets and can be a valuable tool for an investor -- whether on an individual or professional level.

Short selling provides investors with the ability to profit from the decline in a stock's price, hedge positions or portfolios, manage taxes and create arbitrage positions. Since short selling is complex and operates outside of the sight of many investors, short selling is highly misunderstood. So in this installment of The Finance Professor, I will offer a primer on short selling by covering the mechanics behind the short selling process, the account requirements and the federal regulations that govern the transaction.

What Is Short Selling?

Short selling in its most basic form is when an investor takes a stance that a security will decline in value . In doing so, the short seller will sell stock that they do not own. This transaction will trigger a series of processes that ensure that the sale of this stock can take place. I have created the following chart to help walk us through what happens.

Click here for larger image.

Every short sale can involve up to four different parties -- beyond that of clearing organizations , such as depositories and banks, which may also have a role in the transaction. Here are the functions that each player has in the process:

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