What Is a Short Sale in the Stock Market?
Most investors think of the stock market as a place to purchase shares in the hopes that they will rise in value. Such strategies make it possible to profit from increases in share prices. But stock markets do not always go up. During bear markets and at other times, stocks can fall for days or even years. Short selling is a way investors profit from a stock's decline. It is potentially very lucrative but substantially risky.
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Definition
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A short sale in the stock market is the sale of stock by a trader who does not already own the shares. Instead of selling shares she has previously purchased, the trader or investor must borrow shares from her broker to sell them on the open market, anticipating a fall in price. She is obligated to return these shares at a later date. The process of borrowing shares is automatic, and most trading platforms provide this service with no human intervention or extra hassle. After the short sale, the brokerage account shows a negative quantity of shares in its balance for that stock.
Profit
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Stock prices fall more quickly than they rise. This can be due to many reasons, but the most common explanation is that fear is much stronger than greed. Short-sellers who short stock before a major decline can earn handsomely by purchasing the shares later to close out their positions. The profits can be more swift and more lucrative than the reverse strategy, which entails buying and holding shares until they rise in value.
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Risks
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When you buy stock, your total potential risk is limited. The worst-case scenario is that the stock loses 100 percent of its value and falls to zero. You are thus out the entire amount of your investment.
But in short selling, the risks are technically unlimited. If you sell stock you do not own and the prices start to rise rather than fall, there is technically no limit to how high they can go. Stocks that eventually rise to 1,000 percent of their initial value are not uncommon. Short-sellers who are caught in such a losing position can experience catastrophic losses well beyond their initial investment.
Short Squeeze
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The practice of short selling has an ironic side effect: Extraordinarily sharp and rapid rallies that cause a stock to rise quickly in a short period of time. When a declining stock is heavily invested by short-sellers, it is said to have "high short interest." Such stocks are prime targets for the "short squeeze," in which any slight reversal up in price can lead to a snowball effect. All the short-sellers close their positions before they are caught in losing trades. This combined effort from the short-sellers to buy shares and end their short positions causes a large influx of demand to enter the market. Competition among buyers causes prices to rise quickly. This phenomenon is common in bear markets.
Uptick Rule
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The uptick rule was created in the 1930s and remained in effect for nearly seven decades. It directly affects how traders may sell a stock short. As a trading day unfolds, stocks "tick" up and down approximately every second. A "tick" is positive if the combined orders flowing into the market for that stock at that moment cause it to rise in price. This is an "uptick." The uptick rule required that anyone who wished to sell a stock short must wait for an uptick. This rule prevented short sellers from jumping on a declining stock and pushing it down further.
However, the rule was lifted in 2007. Despite efforts to have the rule reinstated, as of June 2010 short sellers could sell stock short regardless of the tick's direction.
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References
- Photo Credit stock market analysis screenshot image by .shock from Fotolia.com
