Short Selling Stocks

Short selling is a useful technique which enables traders to profit in falling markets or in cases where one anticipates a future drop in the price of a particular stock.

When you buy a stock or call option in the hope that it will increase in price, you are said to be "long". On the other hand, you are said to be "short" when you buy put options, in the hope for the market to drop, or borrow a stock in the expectation that you can return or replace this stock at a cheaper price in the future.

An investor "sells short" a particular stock by requesting a broker to lend him the shares. These borrowed shares are then sold on the open market and the proceeds deposited to the investors account.

So what the investor basically did was selling stocks that didn't belong to him, i.e. that he didn't own himself.

And because the shares were only borrowed, the investor must replace and return the shares to the lending broker at some point in the future.
If the stock subsequently falls in price, the investor replaces the shares at a cheaper price. The difference between the two prices (less commissions and other transaction costs) is the investors profit.

You borrow and sell 100 XYZ shares at a current stock price of $100. That's $10.000 in your pocket - for now. The stock then drops to $80 and you decide to buy the stock at that price and return it to your lending broker.This means that you paid $8.000 for these 100 XYZ stocks. The remaining $2000 is yours to keep.This would obviously be the difference between $10.000 and $8.000 or if you like, the difference between $100 and $80 which is $20. And $20 x 100 = $2000.

On the other hand though, if the price of the shares rise, the investor will be obligated to replace the shares at a higher price and thereby taking a loss.

You must have a margin account with your broker before you can short stocks. A margin account lets a person borrow money from a broker to purchase securities. The difference between the amount of the loan and the price of the securities is called the margin.

This means you must maintain a proper collateral in your trading account or you may be subjected to a margin call. This means that whenever the price of securities purchased on margin suddenly drop in price and lose value, a margin call requires the investor to put more money in their account immediately or face liquidation of the securities to pay the loan to the broker back.

Further, not all stocks can be sold short. These include penny stocks, unlisted stocks or stocks which the broker does not have and can not obtain from someone else in order to lend them to you.

In order to sell stocks short you will have to comply with the so-called "up-tick" rule. This rule states that your short sale must be executed at a higher price than the transaction immediately preceding it.

This is intended to prevent the short selling of stocks that are already declining in price so as to avoid sending the stock prices into a free-fall.

Many traders have been burned by the much feared "short squeeze".

If a stock that many people have sold short suddenly starts to rise rapidly in price, many short sellers my decide that it's time to get out. They will then begin buying the stock to replace it. This may induce others with short positions to close them by re-purchasing and replacing the stock.

This extra buying demand will push the price of a stock up further, increasing the losses incurred by those short sellers that have not yet closed their position.

For more information, please sign up here and receive my weekly newsletter. It's free of charge and you can unsubscribe at any time!