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What is a 'Short Sale'

A short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. A short seller makes money if the stock goes down in price, while a long position makes money when the stock goes up. In real estate, short sale means selling a house for less than the mortgage owed with the lender's approval.

BREAKING DOWN 'Short Sale'

Short sellers can buy the borrowed shares and return them to the broker any time before they’re due. Returning the shares shields the short seller from any further price increases or decreases the stock may experience. Brokers borrow the shares for short sale transactions from custody banks and fund management companies that lend them as a revenue stream. Institutions that lend shares for short selling include JPMorgan Chase & Co. and Merrill Lynch Wealth Management.

Securities Short Sale Example

Suppose an investor borrows 1,000 shares at $25 each. Let's say the shares fall to $20 and the investor closes the position. To close the position, the investor needs to purchase 1,000 shares at $20 each, or $20,000 total. The investor captures the difference between the amount he receives from the short sale and the amount he paid to close the position, or $5,000. There are also margin rule requirements for short sales in which 150% of the value of the shares shorted needs to be initially held in the account. Therefore, if the value is $25,000, the initial margin requirement would be $37,500, which includes the $25,000 of proceeds from the short sale. This prevents the proceeds from the sale from being used to purchase other shares before the borrowed shares are returned. Short selling is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales because this strategy includes unlimited losses. A share price can only fall to zero, but there is no limit to the amount it can rise.

Real Estate Short Sale Example

Say Mr. and Mrs. Smith borrowed $400,000 to purchase a home seven years ago. The home was worth $400,000 at the time it was purchased. Mr. Smith loses his job and the couple has a hard time making mortgage payments. Upon reviewing a comparative market analysis, the Smiths learn that the value of their home has dropped, and it is now worth only $310,000. The Smiths prefer to sell their home, rather than seek government-sponsored refinancing options, and ask their lender for permission to sell the home for $310,000. When the home sells, the bank will get less than the Smith's borrowed. In most cases, however, the lender will consider the Smith's mortgage paid in full.

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