Understanding Short Selling
A buy or sell order usually involves the purchase of a given stock at a certain price in the hope that the investor can make a profit by selling the stock later, and at a higher price.
The “opposite” transaction (short selling) can also be carried out: Here, the investor can sell a stock at a certain price and buy it again at a later date. Such an investor hopes that the stock price will fall, enabling him to purchase the stock for less than the price at which he sold it.
How short selling works
An investor who sells a stock short is selling a stock that he does not actually own. In order to make this sale, the investor must first borrow the stock from a broker (in return for a certain fee paid to the broker). Borrowing the stock assures that the investor is selling stocks that actually exist in the market and that can be delivered to the purchaser when the transaction takes place.
After borrowing the stock, the seller sells it on the market through an ordinary sell order. When the investor wishes to purchase the stock, he does so through an ordinary buy order and then returns the stock to the broker.
Short sell is restricted by what is known as the “Uptick” rule. When a stock price goes down, the process of short sell in and of itself can accelerate its own fall.
After the 1929 crash of the NYSE, it was regulated that a short sale cannot be carried out unless the price of the transaction preceding it is higher than was the case during the prior transaction. This rule prevents an artificial drop in the stock price cause solely by the short sale. First scenario: The stock price is $7.50. The investor’s profit is $2.50 multiplied by the number of shares, minus the broker’s commission. Second scenario: The stock price is $12.50. In this case, the investor loses $2.50, which is multiplied by the number of shares, plus the broker’s commission.
Consider an investor who shorted a stock at a price of $10. Changes in the stock’s price create scenarios of profit or loss.
The Risks in Short Sell Price Risk: When a person buys a stock, he can lose only the amount that he paid for it, because no stock price can fall below zero. However, a stock price can rise by more than 100%, which means that a short seller is exposed to a theoretically unlimited loss. In order to cover the possibility that an investor might be wrong, and that the stock price may go up instead of down, he must deposit a guarantee with his broker to assure that the investor will be able to cover his short position, if that should prove necessary.
- Security risk: The amount of the guarantee that an investor must deposit with the broker is based on the value of the borrowed stocks. If the stock price goes up, the broker may demand that the investor deposit additional guarantees to ensure that he will be able to cover the short position.
- Cover short: The broker can require the investor to cover his short position at any time. The timing of such a demand can be crucial to the investor because it may force him to buy the stock at a higher price than the sale price thereby resulting in a loss on the transaction.
- Short risk: It is possible for many investors to take a short position on a certain stock. When the price of such stocks rise, and the investors who sold the stock short discover that they were wrong in thinking that the price would fall, they will try to cover their short position by repurchasing the stock, and sometimes at any price that is offered.
This can aggravate the situation by forcing the stock price higher, which increases investors’ losses from short selling. This situation is called a “short squeeze”.
Warning: Short selling is considered a risky investment, which is primarily undertaken by certified investors. An investor should therefore consult his broker before making such an investment.