Learning how the stock market works might feel a little like trying to learn a foreign language at first. Once you’ve got a good grasp on the basics, you can delve into some of the more complex nuances, like short selling stock, and before long you’ll be able to speak fluently with the Wall Street natives.
Usually you want to buy stock when it’s low and sell it when it's high, but in a short sale the object is to make money when the price of a stock drops. It sounds a little more confusing than it actually is. Basically, once you find a stock that looks like it is about to peak, you borrow a certain number of shares from an investment firm, which they either have in their library or can get from other investors. You immediately sell the borrowed stock at the peak price. You still have to return what you borrowed so once the price drops, you buy the shares back and return them, keeping the difference between the price you sold them for and the price you bought them for.
Let’s walk through a short sale for a better understanding. You think that Stock A is about to peak at $100 per share so you borrow 100 shares and sell them immediately for a total of $10,000. The price per share drops to $90 before you have to return the shares you borrowed, so you quickly buy back the 100 shares you sold for a total of $9,000 and return them to the lender. You profit the $1,000 difference, although you will typically need to pay transaction and brokerage fees.
The U.S. Securities and Exchanges Commission (SEC) monitors short sales and works to ensure no one abuses the system. Short selling to intentionally compromise the price of a stock is prohibited. Under Regulation SHO, brokers are required to have sufficient reason to believe a stock can be borrowed and returned by the due date and they are also required to adhere to a “close-out” requirement, meaning if the stocks aren’t returned by the delivery or extended delivery date, the brokerage firm will reimburse the original lender.
Pros and Cons
The potential to make a fast profit is the most alluring aspect about short selling stocks. You don’t have to actually spend any money because you are borrowing the stocks. The downside is pretty obvious. If you’re wrong about a particular stock and the price continues to increase after you have sold it, you’ll wind up losing money to buy the shares back in time for delivery.
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