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. You might sell short if you believed the price of a security was going to drop significantly 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:
- You borrow a security from your broker.
- You sell it at its current price.
- You buy the security back when you believe the price has fallen sufficiently or the broker calls for it (which ever comes first).
- You return the security back to the broker.
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 capital gain 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. Your broker can call the security at anytime 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.
Now that you understand some of the risks and rewards, let us look at how selling short can be used to "hedge" your investment risk.
THE CONCEPT OF HEDGING
If you are unsure of how the price of a security is going to move, you can hedge. In hedging, you take a position that protects you from an adverse price movement. For example, you may own a stock you believe will do well over the long term, but you are fearful its price may imminently tumble. You might sell short against the box. Although you own the security, you borrow additional shares to sell short. This preserves your "long" position. If the price drops, you replace the borrowed securities and make a gain on the transaction. If the price increases, you have the option of repaying the loan with shares you already own.
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 TAKE ADVANTAGE OF THE SHORT SALE?
In order to sell short, you must have a margin account with your
broker. 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 tutorial Introduction
to Margin Accounts for more information about borrowing from your broker.
This concludes our tutorial on selling short.
