Selling Stocks Short

Selling short involves borrowing securities or stocks you believe will decline in value and then selling them. Keep in mind; you are selling securities you do not own. Put another way, short selling is about selling high and then buying low, just the opposite of buying stocks or other investment securities. Once you have sold your securities, you hope that the price falls, in which case you buy them back at a lower price; the difference between your sell price and your buy price in this case is your profit. If the price rises, you may be forced to buy the shares back at the higher price, losing money on the transaction. Remember, you have to buy your shares back because you must return them to the brokerage firm. In this article about the short sale we will discuss the following: * What does it Mean to Sell Short? * What Are the Potential Advantages of Selling Short? * What Are the Potential Risks or Problems When Selling Short? What does it Mean to Sell Short? Let’s assume you are under the impression that the company XYZ is overvalued and set to decline. How can you profit from this decline assuming you are correct? Believe it or not, it is possible to profit from a stock’s decline by selling its shares short. To sell a company short, you “borrow” shares that you do not own from your broker and sell them on the open market with the intent of purchasing the same number of shares back in the future. Because the shares have been borrowed, you must at some point buy them back returning them to the broker you borrowed them from. Here is a summary of how selling short works: 1. You borrow a stock or security from your broker. 2. You sell it on the open market in the same way you would sell shares in a company you own. 3. You buy the shares back when you believe the price has fallen sufficiently or when the broker compels you (whichever comes first). 4. You have now repaid the loan you took from your broker. As an example, let’s say that you really believe that Widget, Inc. (XYZ), which is currently trading at $100 per share, is going to fall. You borrow 100 shares of XYZ from your broker and sell them on the open market for $10,000. Luckily for you XYZ does indeed see a price decline. Soon, the stock drops to $40 a share, at which price you decide to buy the 100 shares back at a cost to you of only $4,000. Because you sold the shares you did not own at $10,000 and were able to return them to the broker at a cost to you of only $4,000, you get to keep the difference as your profit. You come out $6,000 ahead (before commission and interest). On the other hand, if Widget, Inc. does not in fact fall, but instead keeps on rising after you sold it, you will incur a loss. Let’s say it rises to $150. It will cost you $15,000 to buy those back the 100 you sold at $10,000. Thus, you incur a loss of $5,000; the difference between the price you sold the shares and the price you were forced to buy them back at. What Are the Potential Advantages of Selling Short? Investors sell stocks short as a way to profit during a declining market or as a way to hedge against losses for investments that they own. Let’s say you are under the correct impression that the market is about to decline. You have the option of selling the stocks you own. By doing so you protect yourself against loss but if your account is sitting in cash during the market decline it is also not making you any money. On the other hand, if you correctly believe the market is going to decline and you sell “borrowed” shares from your broker, your investment accounts will continue to gain money even as the market declines. What Are the Potential Risks or Problems When Selling Short? As with any investment strategy, there is risk. If you are incorrect and prices move up from the price you sold short, you may be forced to repurchase the borrowed shares at a price higher than you sold it for. In addition, when you are short a security, you are responsible for paying any interest or dividends the company distributed to the investor you borrowed it from. Moreover, at any time the broker can “call in” the shares, requiring you to return them immediately regardless of the price at the time they make their demand. This can occur for one of two reasons; 1) the price moved up too much from your sell price, so the broker forces you to buy so that they do not incur a loss so large you are unable to repay, or 2) if the broker needs the shares back due to buyer demand. It’s also important to remember when selling stock short that profit potential is limited if you are correct; if you buy a stock the upside potential is unlimited, but if you sell a company short, the downside is limited to 100% as a company can not be worth less than zero. The big however is that your loss potential is theoretically unlimited as the price can move up 100%, 200% or even 1000% or more after you sold short. This is the reason it is very important to use stop losses on your position when you sell short; or when you buy stocks for that matter. Donald D Harder is an investment advisor with over 17 years professional market experience and is President and Chief Stock Market Analyst for Securities Research Services, an online stock trading newsletter service. Don served as a financial advisor for American Express Financial Advisors and later served on the board of directors at Nettrader.ru, a mid-sized Moscow-based online securities brokerage. Mr. Harder strictly adheres to an investment philosophy that focuses primarily on reducing risk, for if you manage risk, profits generally take care of themselves.