Understanding Short Selling a Stock
Short selling a stock occurs when a trader sells borrowed shares so that he can profit from a decline in the price of the stock.
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How It Works
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Brokers can lend out customer securities in margin accounts without the customer's consent. A short seller borrows from his broker shares in a stock he does not own, then sells them and keeps the proceeds. When a stock has declined in price, the trader buys back the shares (covers, or closes out his short position) and returns them to the broker.
The Profit
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The key to understanding short selling is that the transaction is based on the number of shares, not dollar amounts. For example, a short seller borrows 500 shares of XYZ currently trading at $50 and sells them. He gets $25,000 and owes the broker 500 shares of XYZ. XYZ declines to $35. The trader buys back 500 shares for $17,500 and returns them to the broker. His profit is $25,000 - $17,500 = $7,500.
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The Risk
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The risk, of course, is that instead of going down, as the short seller expects, XYZ goes up, forcing the traders to buy back at a higher price. If he buys XYZ back at $60, he loses $5,000 on the transaction.
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References
- Photo Credit pen showing diagram on financial report/magazine image by Anton Gvozdikov from Fotolia.com
