Short Selling In A Nutshell

Most investors think that when the stock market is going down, you cannot make any profits. Well, they are wrong because there are traders out there who are able to easily earn profits when stocks are tanking. You can also do this by using a technique called short selling (or shorting).

Short selling is not really complicated. However, many people have trouble grasping this concept. Generally, people invest by purchasing an asset with the expectation that it will appreciate in price. Eventually, they will sell the asset at a higher price to make a profit.

Short selling is the same process but in reverse. Traders short sell a stock with the expectation that its value will decline. When the shorted stock declines in value, it can then be purchased at a lower price, thereby earning profits.

Essentially you are borrowing the stock from your broker and selling it at a higher price. Once it declines in value, you buy it at a lower price on the open market and deliver it back to your broker. The process of buying back a shorted stock is called short covering. The difference between the higher short-selling price and the lower short-covering price is your profit. It's important to note that there will be a loss if a shorted stock goes up in price.

You should be aware that short selling entails a lot of pitfalls and unique risks. As compared to normal buying & then selling transactions, the short sale mechanics are slightly different.

For instance, say you predict that the stock of a certain company will decline in price in the coming months. If this is your prediction and you're confident about it, you can start by short-selling that stock. You need to have a margin account in order to sell stocks short. A margin account allows the broker to extend credit to you in accordance with Federal Regulation T of the Federal Reserve Board. If you do have a margin account and you place an order to sell short, the broker will check to see if you have sufficient cash in your account to satisfy Reg T.

This means that you must have at least 50% of the amount involved in short-selling the stock in your account as cash. This cash shows that you have sufficient funds available to buy the stock back should it go against you (start rising instead of falling).

Once the broker verifies that you have sufficient cash in your account to make the trade, he or she will borrow the requested shares of stock, and credit your account for the amount received from selling the stock.

For example, in the case of selling short 100 shares of ABC at 30 Dollars, you would need to have half or 1500 Dollars cash in your account and you would receive a credit of 3000 Dollars less commissions. Overall, you would have a credit balance of 4500 Dollars in your account.

Can you go out and spend this money? Not on your life. At least not until the price of the stock starts going down. Let's suppose ABC goes to $20 per share. You've made 1000 Dollars. Your credit balance is still 4500 Dollars, but the market value of the stock is only 2000 Dollars. So your equity is 2500 Dollars, (4500 Dollars - 2000 Dollars). Although your paper profit is 1000 Dollars, your buying power is now 2500 Dollars. This is the amount you can spend to buy stocks long or sell stocks short.

Although you will always pay interest on money you borrow from the broker, most brokerage houses do not pay interest on the proceeds of short sales. You may, however, be able to negotiate an interest payment if you have a sizeable account. You will also be charged by the broker for any cash or stock dividend payments on your short positions.

Short selling involves unique risks so you need to be careful. New investors are not advised to try this kind of trading because they still lack trading knowledge. Start with buying stocks first before venturing into the realm of short-selling. As you gain confidence and experience, you can also try short selling but you must use a stop-loss order to minimize risk. Learning is the best way to equip your-self with the right knowledge in trading. Good luck.