How Do Short Sales on the Stock Market Work?

by Kenneth Hamlett, Demand Media
    Bearish investors can short stocks in an effort to make substantial profits.

    Bearish investors can short stocks in an effort to make substantial profits.

    Selling short, short sell and shorting do not refer to your cousin Vinny’s height, they refer to the act of selling a stock you don’t own in the hopes that the stock’s price drops. Many savvy investors sell short to make financial gains from plummeting stock prices or to hedge a long position they own in the same stock. However you use them, not everyone can tolerate the risk involved.

    The Short Sell

    You have an inkling that a particular company’s stock price will drop. What can you do to capitalize on the stock’s falling value? You can sell it short. But wait, you don’t own it so you can’t sell it, right? Well, not exactly. Selling stocks short does not require initial ownership of the stock at all. It does require a different type of trading account than the one you probably have, but you don’t have to own the stock first.

    In Short

    Once you decide to short a stock here’s what happens -- your broker determines if you have enough collateral in your margin account to make the trade. Now get this, if you do have enough collateral in your account your broker loans you up to 50 percent of the stock’s purchase price in cash or from his house inventory, another client or another brokerage firm. If you get lucky the stock’s price falls. When it does, you immediately buy the stock at the lower current market price and in a simultaneous transaction sell the stock you borrowed from your broker at the higher price (yes, someone will buy it at the higher price). The difference becomes money in the bank, minus any fees and commissions of course. Don’t forget you still owe the broker, but that can get settled later.

    Trading on Margin

    Margin is a very powerful two-edged sword. It can financially make or break you. When you trade on margin, you borrow money or securities from your broker and use the securities as collateral. In order to sell stocks short you must have a margin account. Like any loan, your broker charges you interest on the borrowed money. Here’s how margin works -- if you pay $10,000 in cash to buy stocks and the value rises to $20,000 you’ve made 100 percent profit. If you pay $5,000 in cash and your broker loans you $5,000 and the value increases to $20,000 you’ve made 150 percent profit on your money. Of course you still owe your broker for the loan plus any accumulated interest.

    Risky Business

    Selling short is risky business. A number of factors can work against you. First and probably the most obvious is the price of the stock could increase and not decrease. In that case, you would lose all of your investment and still owe the broker for the loan. On top of that, the Federal Reserve Board, NYSE, other regulatory agencies and your broker all have rules regarding margin trading. If the price of the stock goes up and the equity in your margin account falls below the required minimum, your broker can give you the dreaded margin call. If that happens, you must come up with immediate cash or securities to bring your account up to the minimum requirements.

    About the Author

    From 2002-2006, Kenneth Hamlett was publisher and head writer for UNSIGNED Music Magazine, an online publication with over 100,000 readers. Prior to establishing UNSIGNED, Hamlett was a business solutions analyst and spent 15 years formulating and writing proposals for supply chain business solutions. He is a graduate of the New York Institute of Photography.

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