What Does Selling a Stock Short Mean?
When investing, most investors will research stocks and buy shares hoping that the price of the stock will rise. However, not all stocks go up -- bad earnings reports, changes in industry dynamics or other negative events can hit a company and cause the shares to fall. If you seem to have a knack for picking stocks that go down versus go up in price, you may want to consider short selling the stock.
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The Basics
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When you decide to sell shares of a company's stock short, you will earn profit only if the shares of the stock decline in value. When your order to short-sell a stock is executed, you will immediately receive the funds in your account for this transaction. Unlike buying shares where your cash balance is reduced to cover the purchase, when you short-sell shares you receive the proceeds and your cash balance rises. For instance, if you sell 100 shares of a $10 stock short, your cash balance will increase by $1,000. Your objective is to buy the shares back at a lower price and keep the difference. For instance, if you closed the above short position at $9 -- or bought to cover -- your cash balance will be reduced by $900 and you will keep the $100 as your profit.
Risk of Loss
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When you buy a stock, your upside is unlimited and you can lose only what you paid for the stock. When you short-sell a stock, your maximum profit is the amount of proceeds you received and that is only if the stock goes to $0 per share. If you short-sell a stock and the stock price starts rising, your downside is unlimited and you can lose a lot more than your initial investment. If a stock price rises fast, you may have to buy to cover and pay more for the shares you sold short.
Additionally, stockbrokers will want to make sure you have enough funds in your account to cover the potential closing buy to cover transaction. If a stock price starts rising, you will have to have more cash on hand to potentially close out the position. Your broker may even ask you to deposit more funds immediately to cover this amount or automatically close out your short position to eliminate its exposure to higher losses.
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Borrowing Shares
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Behind the scenes of a short sale, much more is happening than betting that the stock price will go down. When you sell shares short, you are selling shares of stock that you do not own. To accomplish this, you are borrowing the shares from another shareholder willing to lend you his stock to complete the transaction. In some cases, a broker will be unable to locate a shareholder willing to lend his shares for a short-sale transaction and you will not be able to sell the stock short.
Paying Dividends
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Since you are borrowing the shares from a shareholder, if the company pays dividends, you will be required to pay the dividends to that shareholder each time the company pays out. That is, if you short a stock with a consistent quarterly dividend policy, expect to have funds withdrawn from your account on the dividend pay date. This expense also needs to be considered when selling a stock short.
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