Stock Market Definition of Short Sell
Short selling a stock basically is a belief that the price of a particular stock will fall, thereby providing you with a profit. The basic mechanics are fairly simple: You borrow a security from a broker and sell it, agreeing to pay back the lender within a given period of time. You are banking on the stock price falling, allowing you to buy the stock at a lower price, repay the lender and pocket the difference between the high price at which you sold the stock and the lower price at which you bought the stock.
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Why Sell Short?
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Most people buy stocks with the idea that the value of the company in which they are investing will increase --- thus increasing the value of the stock. However, many seasoned investors recognize overvalued stock --- or think they recognize such stocks --- and choose to bet against the stock price continuing to rise. By betting that a stock price will fall, an investor can borrow stocks at the current (relatively) high price, sell them at the current high price, then buy identical shares back in the market at a lower price when the price falls. In this way, you pay back the broker or other lender with shares that you purchased for less than they were worth when you borrowed them. The difference in price represents your profit (minus brokerage fees or any potential dividends the securities would have paid during the transaction period).
How It Works
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You open up a margin account with a broker (you could use your own cash, but that defeats the purpose of the speculative nature of the transaction, and you'll need cash to cover any possible margin calls). The broker agrees to lend you X number of shares of a stock, to be paid back with a set time period. Let's say that you spot a stock you believe is overvalued. It's selling for $100 a share. You borrow 100 shares from the broker (a $10,000 value). You immediately sell the shares at face value, pocketing the $10,000. During the grace period, the price of the stock falls to $50, at which time you buy back 100 shares for $5,000 (100 shares times the new, lower price of $50 per share). You turn around and pay back the broker his 100 shares and walk away with a $5,000 profit, minus any fees owed.
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Dangers
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The obvious risk is that the price of the stock will increase further, and not fall, as you had hoped. In that case, you still are on the hook for repayment to the broker of the shares you borrowed. Using the same example as above, let's assume you sell the shares that you borrowed for the same $10,000. During the grace period, the price of the stock rises to $150 a share. You still are obligated to repay the broker his 100 shares. And remember, you don't own the stock. You borrowed the stock and sold it, anticipating that the price would fall and you could buy shares back at a bargain price. Now that the price has increased, you must buy 100 shares at the new price of $150 a share ($15,000) and pay them back to the broker. You're out $5,000.
Considerations
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Despite the seeming simplicity of the logic and transaction, short selling should be done only after careful consideration. Some stocks aren't available for short selling, either because a small number of investors own the stock or there's already a large short position on the stock. You also want to make sure the stock is fairly liquid so that you can easily sell and buy it during the grace period. You should be an experienced investor who can independently recognize overvalued stock and short-selling opportunities. You also need to be wealthy enough to be able to cover margins calls or losses. And remember, unlike traditional stock transactions, short selling has no limit on the amount of money you can lose.
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- Photo Credit stock market image by Sydney Alvares from Fotolia.com
