A short sale is simple in principle. You sell your broker shares of stock you don’t own, with a promise to deliver them in the future. If the stock falls in price, you can buy the shares you must deliver for less than your broker must pay you. Your broker goes along with this deal because both of you must follow strict rues set by the Federal Reserve Board and the Securities and Exchange Commission.
Before you can sell stock short, you have to meet a couple of conditions. First, you need a margin account. This is the type of trading account that lets you borrow money or securities from your broker. Second, you have to deposit enough funds to meet margin requirements. The Federal Reserve Board sets a minimum margin requirement of 50 percent (as of 2010). This means you have to have sufficient funds in your account to cover the cost of the stock plus 50 percent. The reason for this rule is to make sure you have enough money on hand to purchase the stock when the time comes, even if the price goes up instead of down.
Your broker loans you shares of the stock you are selling short. The shares are placed in escrow. This procedure is required by the Securities and Exchange Commission and guarantees that the shares you need to buy in order to complete the short sale are available. Occasionally, your broker may not have the shares in his inventory or may not be able to borrow shares to lend to you. In this event, you won’t be able to do a short sale.
Once you sell a stock ,the transaction is called “open” until you buy and deliver the shares (called closing the short sale). As long as the short sale is open you must keep a minimum maintenance margin. As with your initial margin requirement, the maintenance margin consists of the value of the stock when you opened the short sale, plus a percentage. Brokers typically want a maintenance margin of 30 to 40 percent. Suppose you sell short on $4,000 worth of stock. Your initial margin is $6,000. If the stock goes up so the stock is worth $4,500, your percentage margin becomes $1,500 divided by $4,500, or 33 percent. At this point your broker is likely to issue a margin call and you must deposit additional funds. If you decide not to add money to your account, your broker will close out the short sale and you will take a loss.
At some point you will decide the market price of the stock is right or that it’s time to cut your losses. To close out the short sale, you buy the stock on the market that you need to deliver to the broker. Your broker buys the shares at the original price and you return the borrowed shares. This is actually simpler than it sounds because all you have to do is tell your broker to close out the short sale. Your broker takes care of the rest. Your profit (if any) minus fees and interest on the funds represented by the borrowed shares will be deposited in your account. Because you did not actually own the shares while the short sale was open, profits are not eligible for long-term capital-gains tax rates and you can’t collect any dividends that were issued.