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Selling ShortIntroductionSelling short involves borrowing securities you believe will decline in value and then selling them. You are selling securities you do not own. Looked at another way, short selling is about selling high and then buying low, just the opposite of regular trading. Once you have sold your securities, you hope that the price falls, in which case you buy them back at a lower price. If the price rises, you may be forced to buy the shares back at the higher price, losing money on the transaction. Remember -- you have to buy them back because you must return them to the brokerage firm. In this section about the short sale we will discuss the following:
What Is a Short Sale?A short sale occurs when you "borrow" a security from your broker and sell it with the intent of re-purchasing it in the future to repay the loan of the security. You might sell short if you believed the price of a security was going to drop and you could re-purchase it at a price significantly below the price for which you sold it. You may have a "long" or "short" position in a security. When you have a "long" position in a stock or bond, you actually own the security in your account. On the other hand, sometimes you may want to take advantage of a price movement in a security you do not own. When you do this, you may take a "short" position by borrowing the security. Here is how selling short works:
As an example, let's say that you really believe that Chocolate Beer, Inc. (XYZ), which is currently $10 per share, is going to fall very far and very fast. You borrow 100 shares of XYZ from your broker and sell them for $1,000. Soon afterward, the stock drops to $4 a share, at which price you buy the 100 shares back for $400. You come out $600 ahead (before commission and interest). If Chocolate Beer, Inc. becomes a hit and its price rises, you will take a loss. Let's say it rises to $15 by the time you must repay the shares. It will cost you $1,500 to buy those 100 shares back. Thus, you must pay $1,500 to replace the shares you sold for $1,000. You must also pay commission and interest costs as well. Dividends or interest earned on the shorted security belong to the person from whom you borrowed it. The broker can also demand that you return the shares at any time regardless of whether the price is up or down.
What Are the Potential Rewards of Selling Short?Investors use short sales to make gains in a declining market or to hedge against losses in an investment. If you sell short, and buy back at a lower price, you stand to make larger gains than if you had a long position in a security that declines in value. For example: you borrow 100 shares from a corporation, which has a market price of $35. You sell the 100 shares for $3500. The price later falls to $25. You buy back 100 shares for $2500. You have made a profit of $1000 ($3500-$2500).
What Are the Risks of Selling Short?As with any investment strategy, there is a downside. If you are incorrect, you may have to re-purchase the borrowed security at a price higher than you sold it. In our previous example, if the price of the corporation increases from $35 to $40 and you have to buy the shares back, you have to pay $4,000 and you lose $500. While you have a "short position" in a security, you are responsible for paying any dividends or interest it distributed to the investor you borrowed it from even though you did not receive it either. The security can be called at anytime by your broker and you must return it immediately regardless of the market price. A very important thing to remember when selling short is that you have only a limited amount of money you can earn if you are correct. However, your potential to lose money has no limits. This is true because the money you can make is restricted to the difference between the stock's current market price and the floor price for all securities - $0.00. Whereas, a security can hypothetically appreciate indefinitely. This means that when you sell short, your losses could accrue indefinitely if you do not close out the position. To take advantage of selling short you will need a special brokerage account. Read below to learn more.
What Kind of Brokerage Account Do I Need to Make a Short Sale?All orders to sell a security short must be placed in a short account. You must have margin privileges with your brokerage firm in order to have a short account. Since selling short requires that you borrow from your broker, you will need to establish credit with your broker and abide by the rules for borrowing against your account. See the section Introduction to Margin Accounts for more information about margin accounts.
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