How to Sell Stocks Short - dummies

By Michael Griffis, Lita Epstein

Selling stocks short is common in the trading world. When you sell a stock short, you sell something you don’t have first and buy it later with a goal of profiting from a falling stock price. To sell a stock short, you borrow shares of a stock from your broker to sell them in the open market. Your broker gets those shares from its own inventory, or from other clients.

The proceeds of that sale go into your account. To close that position, you must buy the shares on the open market and return them to the broker. If the price you pay for the stock, or the buy-to-cover price, is less than your selling price, you’ve earned a profit on the short sale. Conversely, if the buy-to-cover price is higher, you’ve suffered a loss.

Say you borrow 100 shares and sell the shares short for $100 per share. When the price drops to $80 per share, you buy the shares back and return them to your broker. You sold the stock for $100 per share and bought it back for $80, netting a profit of $20 per share. It’s the same if you purchase the stock for $80 and sell it later for $100.

Conversely, say you borrow 100 shares of Company Y and sell them for $100 per share. The stock price rises to $120 per share, and you decide to cover your loss. You buy back the shares and pay $120 per share, but you sold them for $100 per share. You have lost $20 per share on this trade.

Some of the quirks that are unique to selling stocks short include

  • Paying dividends to the lender. If the stocks pay a dividend during the time a short seller holds a position, short sellers pay the dividends on the ex-dividend date to the people who loaned them the stocks. Short sellers need to keep the ex-dividend date in mind whenever shorting stocks.

  • Being forced to close a position. Whenever the original owner sells the stocks you borrowed, your broker can call away the shorted shares, which means your broker can force you to return the borrowed shares by buying them on the open market at the current price. This happens rarely and occurs only when no shares are available for shorting.

  • Mandating the execution of short sales from only a margin account. Short sales must be executed in a margin account because your broker loans you the stock to sell short and charges you interest on any margin balance in the account.

  • Paying margin maintenance requirements. Your broker can force you to close a short position if you’re unable to satisfy maintenance margin requirements.

  • Having no or only minimal access to selling some stocks short. Lightly traded stocks may be unavailable for selling short, and when they can be sold short, they may be more likely to be called away (which happens when the original owner sells the stock you borrowed and your broker is unable to borrow additional shares).

  • Restricting short sales on certain stocks. You can’t short a stock that’s less than $5 per share, and you can’t short initial public offerings (IPOs), usually for 30 days following the IPO. And, as became evident during the credit crisis, regulators can prohibit short selling on whole categories of stocks.

  • Limiting short selling to only stocks on an uptick. This uptick rule was eliminated in July 2007, but a modified version was implemented again in 2010. The essence of the old rule was that you couldn’t sell a stock short in a falling market. Short sellers could not easily pile into a falling stock. The 2010 rule does not apply to all securities.

    Today it’s only triggered when a security’s price decreases by 10 percent or more from the previous day’s closing price. The rule then stays in effect until the close of the next day. However, many people consider this new version of the rule to be ineffective.

One unusual aspect of shorting is that it creates future buying pressure. Every shorted sale must be covered, and that means that every share of stock that’s been shorted must be repurchased. Future buying pressure can cause the price of a heavily shorted stock to jump dramatically if all the short sellers simultaneously clamor to get out of their positions as the price rises, a situation called a short squeeze.

You can find out how many others are shorting the stock by looking at short-interest statistics published in Barron’s and Investor’s Business Daily near the end of each month. From those statistics, you get some idea whether your short position is likely to be squeezed.