Short Sale of Stocks Defined
Short-selling stocks is an investment strategy that earns a return for the investor when the price of a company's stock goes down. In traditional trading, investors buy shares to make a profit when the share price goes up---a strategy known as going long on an investment. An investor goes short when anticipating a decline in share prices, and long when she believes prices are going to go up.
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Account Types
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An investor buys shares through an intermediary known as a stock broker. Depending on the type of account opened with the broker, an investor may use his own funds to purchase shares, or borrow money from the brokerage firm. In a cash account, an investor pays for stock with his own money, whereas in a margin account, the broker lends money to the investor for the purchase. Only margin account holders are able to short sell, because the process involves borrowing from the brokerage firm.
The Short-Sale Transaction
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When an investor short-sells a stock, she actually borrows the shares from the broker. The broker lends the stock either from its own inventory, another account holder at the firm, or from another brokerage. The firm conducting the short sale for its customer lends the stock, then sells it on the customer's behalf and credits her account. After the sale, the customer must "cover the short" by buying back the stocks and returning them to the broker. Since short-selling is done when the investor anticipates a drop in share price, she can make a profit when she buys the shares at the lower price, and returns them to her broker.
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Profiting from Short-Selling
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An investor makes the short-sale decision after carefully studying a particular company or industry. For example, if the investor believes that a stock priced at $15 is going to go down to at least $7 in the near future, he might decide to short-sell. The investor uses his margin account to place an order with the broker, who borrows the shares and sells them at the market value of $15. If the order is for 100 shares, the investor's account is credited with $1,500.
When the share price dips to $10, the investor buys back the stock and replaces the shares borrowed from the firm. Since he buys each share for $10, and sells each share for $15, the investor makes $5 profit per share, giving a total profit of $1,000 for the 100 shares.
Risks
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As with going long, investors who short-sale stocks also assume risk of losing money. In the above example, if the price of one share actually went up from $15 to $18 instead of declining in value, the investor would lose money. This is because he would have to buy back the shares at a higher price than what he sold them for. Another source of risk in short-selling is the interest charged on margin accounts. As the broker is actually lending funds to the investor, it will charge an interest for as long as the shares are not returned. Consequently, keeping an open short-sale costs more.
Short-Sale Considerations
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Since the investor does not own the shares he shorts, he must pay the lender---the brokerage---any dividends or rights, such as stock splits, during the loan term. In case of a stock split, the borrower will owe twice the number of shares valued at half the original market price.
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References
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