Stocks: What is Short Selling?
Short selling isn't terribly complex, but it is a concept that many investors
have trouble understanding. In general, people think of investing as buying a
security and then selling to
make a profit. Shorting is the opposite; you make money only when a
shorted security falls in value.
Going long on an investment means an investor has bought a stock believing that
it’s price will rise in the future. The opposite is going short, which is when
an investor anticipates a decrease in share price.
Selling short is the sale of a stock that you don't own
by borrowing it from your broker. That may sound a little confusing, but it's actually a
simple concept. When you sell short a stock your broker will lend you the
security. The stock will come from the brokerage's own inventory, another one of
the firm's customers, or from another brokerage firm. The shares are sold and
the proceeds are credited to your account. Sooner or later you must "close" the
short by buying back the same number of shares (called covering) and returning
them to your broker. If the price drops, you can buy back the stock at the lower
price and make a profit on the difference. If the price of the stock rises, you
have to buy it back at the higher price, and you lose money.
Most of the time, you can hold a short for as long as you
want. You can, however, be forced to cover if the lender wants back the stock
you borrowed. They can't sell what they don't have, and so your brokerage will
have to either come up with new shares to borrow, or you'll have to cover. This
is known as called away. It doesn't happen very frequently, but is possible if many investors
are selling a particular security short.
Here is an example of selling short and what can happen. The stock is trading at $100
currently and you think it will trade much lower in the coming months. You
decide to take the plunge and short 100 shares.
One of two things can happen in the coming months:
|
The Stock
Price Sinks
(stock goes to $40)
|
|
Borrowed 100 shares of XYZ at $100 |
$10,000
|
| Bought Back
100 shares of XYZ at $40 |
-$4,000
|
| Your Profit |
$6,000
|
|
The Stock
Price Rises
(stock goes to $120)
|
|
Borrowed 100 shares of XYZ at $100 |
$10,000
|
| Bought Back
100 shares of XYZ at $120 |
-$12,000
|
|
Your Loss |
-$2,000
|
Clearly, short selling can be profitable. But just as with
buying long, there is no guarantee that the price of a stock will go the way you
want and there are many risks involve in shorting.
|
Dividend, interest and margin issue
|
Next==>>
Risks &
Reasons for short selling
|
