Short Selling: What Is Short Selling?

First, let’s describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most commonly used. They serve as an intermediary between the investor and the seller and often charge a fee for their services.
{C}When using a broker, you will need to set up an account. The account that’s set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends you a portion of the funds at the time of purchase and the security acts as collateral.

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn’t own. More specifically, a short sale is the sale of a security that isn’t owned by the seller, but that is promised to be delivered. That may sound confusing, but it’s actually a simple concept. (To learn more, read Benefit From Borrowed Securities.)

Still with us? Here’s the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage’s own inventory, from another one of the firm’s customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must “close” the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can’t sell what they don’t have, so yours will either have to come up with new shares to borrow, or you’ll have to cover. This is known as being called away. It doesn’t happen often, but is possible if many investors are short selling a particular security.

Because you don’t own the stock you’re short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stocksplits during the course of your short, you’ll owe twice the number of shares at half the price. (To learn more about stock splits, read Understanding Stock Splits.)

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