Short selling involves purchasing borrowed shares, selling them and, ideally, returning to the lender the shares which experienced a decrease in price. The investor profits by buying high and selling low, as the investor has a bearish outlook on the company's prospects. In accordance with SEC and exchange rules, stock may be sold short only on a plus tick or zero-plus tick. A plus tick is a price higher than the last different price. The rules are designed to prevent short sellers from feeding orders into a declining market to manipulate a stock's price downward. The maximum gain on a short sale is the difference between the price at which the sale is initiated and zero minus any commissions. The maximum loss is potentially unlimited if the price of the stock rises. The mechanics of a short sale are as follows:
- The investor opens a margin account.
- Based upon her research and negative outlook for the company, she initiates the short sale of a round lot of the company's shares at the current market price of $15 ($1,500).
- The client borrows the shares. Margin accounts allow the broker to lend shares. Large, well-known companies are more likely to have stock available to be sold short.
- The investor sells the shares, depositing the proceeds in an escrow account.
- The client covers her short position - with the share price down to $5, the client has the broker buy a round lot of shares for $500.00. The client collects $1,500 and clears $1,000.
Hedging and Options Strategies
InvestingShort sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
TradingThis strategy can help in market downturns, but it's not for inexperienced traders.
InvestingIf more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
InvestingShort selling has a number of risks that make it highly unsuitable for the novice investor.
TradingThis figure can be a real eye-opener about the market sentiment surrounding a given stock.
InvestingThe media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.