Selling Short Fundamentals

Short selling is a way to profit when a stock price declines in value. Here are some fundamentals to selling short.

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When selling stock, there are two basic positions you can take: selling long or selling short. In the long position, the investor purchases stock at one price hoping the share price rises.

Short Sale Basics

In a short sale, the investor sells stock that he doesn’t own in hopes the share price falls in the future. To complete a short sale, the investor borrows shares from the brokerage. The brokerage can get the shares from their own inventory, from another client’s margin account, or from another brokerage firm. (The government has made it illegal to short sell shares of stock before the shares have actually been located. This process is known as naked shorting.) The brokerage sells the shares and credits the investor’s account with the proceeds from the sale.

Making and Losing Money In Short Sales

If the price falls, the investor buys the shares at the lower price, repays the debt to the brokerage, and keeps the profit. You’re able to make a profit because you have to pay back the number of shares borrowed, not the profits from the original sale. For example, if you short sell 100 shares of ABC stock at $75 per share, your margin account is credited with $7,500. Then, if the price later falls to $50 per share, you purchase 100 shares of the stock for a total of $5,000 and you keep the other $2,500.

However, if the share price increases, the investor has to pay the higher share price and suffer a loss. Let’s say you short sell 100 shares of ABC stock at $75 per share and you buy back the shares at $85 per share. You’ve lost $1,000 in that transaction. Of course, your loss could be greater if you continued to hold your position waiting for the stock price to fall, but it only continued to rise. You could lose an infinite amount of money if the stock price never stops increasing. If you wanted to sell your shares when the share price reached a certain point, you could use a stop loss order.

Margin Account Required

To short sell a stock, investors need to have a margin account with their brokerage firm. The margin account,allows investors to borrow stocks. As with other types of credit lines and loans, margin accounts are subject to interest and fees. Short sellers might also be responsible for paying dividends on the borrowed stock.

When you have a margin account, you’re also required to maintain a certain amount of equity in your account. If your assets fall below that amount, which can happen if the stock prices increases before you’re ready to liquidate, you’ll have to put in more cash or liquidate your current holdings. If you fall below the minimum maintenance requirement, the brokerage firm can issuea margin call where your holdings are sold without much advance warning.

Drawbacks of Short Selling

Certain types of stock, like penny stocks, can’t be short sold. In addition, the SEC requires that short sales must be done in groups of 100. That means you can’t short sell 35 shares of a stock. In addition, the brokerage firm may impose their own trade minimum, e.g. $5,000. You’d have to short sale at least $5,000 worth of stock in some multiple of 100.

There’s also a risk that you won’t be able to buy enough shares all at once at the price that you’re looking for. This might mean you get a lower profit than you’re expecting. Or, it could mean that you’re suffering greater losses than you’d like.

When you shore sell stock, you’re taking a risk because stock prices generally increase over time, even if it’s just from inflation. The longer you hold a short sell position, the greater the risk that you’ll lose money. Lower priced shares also have some added short risk, as there is limited room for decline.

If you like the idea of short selling, but you’re not ready to go there, you can invest in a mutual fund that does short sales, like the ProShares Short S&P 500.