Short selling a stock is a technique investors use to make money when they believe the price of a stock is going to fall. Selling a stock short incurs risk but has the potential for large gains. The procedure for stock short trading is more complicated than for a regular transaction, so you should be sure you understand it before using this trading method.
The trick to stock short trading is to reverse the usual order of buying a stock and then selling it later. In a short sale, you sell the stock at the current price and agree to deliver the shares of stock at a later time. If the price falls in the meantime, you can buy the shares you need to fulfill the agreement for less than the buyer has agreed to pay, and you make a profit.
Because you are selling stock you don’t actually own, a short sale is more complicated than a normal purchase of shares. Most of the details are routine and your broker takes care of them. However, a short sale is a legal contract and you must understand your obligations under this contract. The main thing to realize is that you have to have security to guarantee your ability to complete the contract. You do this by “borrowing” shares of the stock from your broker. Since you are borrowing, a short sale is “on margin” (the broker is loaning you something) and you must have an account with margin privileges. You must keep a minimum balance in your account called the margin requirement. Because the broker is making a loan, you will be charged interest.
Unlike the commodities market, where short sales (called “put” contracts) are a standard part of trading, there is no set date for you to complete a short sale of stock. You may hold the stock as long as you wish, subject to your broker’s policies. There is one exception: if the stock goes up in price, you will be losing money. If the stock goes up too much, your broker will issue a “margin call.” You have to either deposit more money in the account or the broker will close out the short sale automatically.
The stock you have “borrowed” is placed in escrow and returned to your broker when the short sale contract is completed. The broker still owns the stock, so he gets any dividends. Also, since you never actually own the stock, you cannot take a capital gains deduction on any profits. Another thing to remember is that your broker must own shares of a stock before he can loan it to you. Sometimes that won’t be the case, and your broker will not be able to arrange a short sale.
Stock short trading is a short-term strategy, usually lasting only a few weeks or at the most months. Nevertheless, you should be as careful about selecting a stock as you would if you planned to hold it for years. Look for companies that have management problems or that have suffered reversals in their fortunes. You have to be able to act quickly because brokers rarely will arrange a short sale if a stock is already falling in price. The ideal candidate is a company that has announced unexpectedly low earnings or had some other adverse news. It’s also a good idea to take precautions to limit your potential losses if you guess wrong and a stock you’ve sold short goes up in price instead of down. One way to do this is to place a “buy to cover” order at the same time you sell the stock short. This tells the broker that if the stock rises to a stated price, go ahead and buy the shares needed to cover your short sale. That limits your losses.