A short sale order, or a stock sold short, is an order to sell shares that a client does not own. As a result, the trader must borrow the stock from an existing client, sell the shares of the security and then buy the stock again to replace the shares he borrowed. In doing this, there are three rules that must be followed:
- A short sale order can only be done in what is known as an "up market" where the market is appreciating, not declining. This is known as the uptick rule.
- If a dividend is paid on the shares, the investor selling the shares short pays the dividend to the investor he borrowed the shares from.
- An investor cannot borrow shares to sell short without providing some sort of collateral.
An investor may want to sell a stock short if the investor believes that stock is going to decline. For example, a client wants to sell 100 shares of Newco short at $45. The trader sells 100 shares he borrowed from another investor at $45. The amount from the sale goes to the investor selling the shares short. The investor is hoping the shares go below the $45. If, for example, the shares decline to $35, the investor already sold the shares at $45. The investor can thus repurchase the shares at $35 and replace the shares he borrowed. Excluding transaction costs, the investor had made $10 per share on the transaction.
Have you ever correctly predicted a stock's decline or wondered how to be profitable in a bear market? In the following tutorial entitled short selling you can learn more about how short selling works and the risks involved in it.
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