Finally, you will need to know how to use short interest in a margin account. Short selling has been regulated at least since the Securities Exchange Act of 1934, so you can assume it was a common practice even then.

What Is a Short Sale?
A short sale is a sale of stock that an investor does not own. In a short sale, the investor borrows the stock from her broker, and then sells it in the open market with the intent of purchasing it back at a later date and at a lower price.

It is a bearish bet. If the stock declines, the investor profits from the difference between the price at which the stock was sold short and the price at which the stock was purchased to cover the short. If the stock moves higher, the investor loses money.

Since the investor who sells short is not considered the owner of that block of shares; he receives no dividends and exercises no shareholder rights. The lender retains all these. The lender is the broker-dealer, and the transaction is not materially different from the broker-dealer lending the investor money to buy stocks. This is why short sales must always be done through a margin account.

If short selling is a new topic to you, the Short Selling tutorial focuses on how short selling works and the risks involved.

Why Short?
There are three reasons to short securities:

  1. Speculation: If a stock, a sector or the entire market is overpriced, then those who sold short benefit.

  2. Hedging: Most investors use shorts to hedge their positions rather than to establish them. If a large percentage of your client's portfolio is invested in a single stock, you might recommend she sell short enough shares to protect her portfolio in the event the stock takes a dramatic dive.

  3. Tax purposes: Shorting against the box is a tax strategy that shields capital gains on the shares an investor already holds. It is the act of selling short, even though the investor really does own the stock. The short seller's shares are held "in the box" by her broker, so she does not have to sell the shares, which would cause her to have to realize the gain for tax purposes. She will not have to pay taxes on the gain until she covers those shares - that is, returns them to the broker - and that can be deferred until the following year (or indefinitely, at least in theory).

Look Out!
Let\'s say your client wants to sell his 1,000 shares of PQR Corp. stock this year, but wants to defer the tax event until next year. He bought these shares at $50 and they are now trading at $60. When he directs you, his registered representative, to sell them short, you will take the following steps:
  1. Sell 1,000 shares of PQR - from the brokerage account or borrowed from another investor - at market price.
  2. Send the client $60,000 in proceeds from the sale, less a fee that is usually expressed as interest, and notify him that he owes you 1,000 PQR shares.
  3. Expect that the client will cover those shares after the end of the year.

Market Value of a Short Position

Related Articles
  1. Trading

    Short Sales For Market Downturns

    This strategy can help in market downturns, but it's not for inexperienced traders.
  2. Trading

    Short Interest: What It Tells Us

    This figure can be a real eye-opener about the market sentiment surrounding a given stock.
  3. Trading

    Guide to Short Selling

    Want to profit on declining stocks? This trading strategy does just that.
  4. Trading

    The Difference Between a Long and Short Position

    Stocks are owned in a long position and owed in a short position.
  5. Trading

    Difference Between Short Selling And Put Options

    Short selling and put options are used to speculate on a potential decline in a security or index or hedge downside risk in a portfolio or stock.
  6. Managing Wealth

    Value Investing & Short Selling Are Like Oil & Water

    To be a good value investor, you need to find and buy bargain stocks but more importantly, you have to stick to the trade until the market recognizes the worth of these securities.
  7. Trading

    Why is Short Selling Legal? A Brief History

    Short selling -- selling borrowed stock in hopes the price goes down --used to be unregulated.
  8. Investing

    Rules and Strategies For Profitable Short Selling

    Short sales work well in bull and bear markets but strict entry and risk management rules are required to overcome the threat of short squeezes.
  9. Trading

    An Overview Of Short Selling

    Short selling is not as harmful as people think, and actually serves an important function in the market.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center