Purchased assets are said to be held “long”. In contrast, assets which are sold without first owning them, are said to be “short”.

A short sale is the sale of borrowed securities, where the short seller is required to return the borrowed securities on an indefinite future date.

The short seller begins by borrowing an asset from an investor who already owns it (A). He then sells the borrowed asset to another investor (B). At some time in the future, the short seller must end his short position by returning the borrowed asset to A. This closing out of his position is called “covering”. Here is the key feature of a short sale: no matter how the asset price may have changed, the short seller covers by returning the exact number of units of the asset that he had borrowed. In particular, he does not return the same value that he had borrowed.

The time when the short seller must return the borrowed asset is indefinite. It is sufficient that A continue to believe that the short seller is financially capable of doing so. It is not even usually a problem if A wants the asset back so he can sell it. In that case, the short seller continues his short sale by borrowing the asset from yet another investor and returns the newly borrowed asset to A.

The short sale literally creates new securities similar to units of the asset. Indeed, more rights to the asset will then exist than the number of outstanding units. In particular, both A and B will rightly feel entitled to receive any payouts during the life of the short sale. For stock, the corporation paying the dividend, however, will see B only as an owner and therefore will pay only B the dividend. The short seller is now obligated to make up the missing dividend and pay it to A. In this way, short selling is again the mirror image of buying, in that the buyer receives the dividend, whereas the short seller pays it out.

When the short seller receives the proceeds of the sale from B, this money is usually reinvested in fixed income securities. The interest earned is split among the securities lender (A), the broker who arranges the short sale, and the short seller. If the broker can borrow the securities from his own customers, the lender usually receives nothing. More commonly, the broker will borrow the securities from a large financial institution such as an insurance company or a mutual fund. In that case, the lender usually receives most of the interest. Small investors who short sell usually do not receive any of the interest, while large investors, particularly professional market makers, can usually arrange to earn a large portion of the interest. Just how much interest the short seller can earn is a critical variable in determining the advisability of a sale.