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.
There are three reasons to short securities:
- Speculation: If a stock, a sector or the entire market is overpriced, then those who sold short benefit.
- 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.
- 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).
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:
Market Value of a Short Position
InvestingIf more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
TradingThis strategy can help in market downturns, but it's not for inexperienced traders.
TradingThis figure can be a real eye-opener about the market sentiment surrounding a given stock.
TradingWant to profit on declining stocks? This trading strategy does just that.
InvestingThe media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.
Financial AdvisorUnderstand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.