Introduction to Stock Short Sales for Investors - dummies

Introduction to Stock Short Sales for Investors

By Paul Mladjenovic

The vast majority of stock investors are familiar with buying stock, holding onto it for a while, and hoping its value goes up. This kind of thinking is called going long. Astute investors also profit in the market when stock prices fall.

Going short (also called shorting a stock, selling short, or doing a short sale) on a stock is a common technique for profiting from a stock price decline. A short sale is a bet that a particular stock is going down.

To go short, you have to be deemed (by your broker) creditworthy — your account needs to be approved for short selling. When you’re approved for margin trading, you’re probably set to sell short, too. Talk to your broker (or check on the broker’s website for information) about limitations in your account regarding going short.

You must understand brokerage rules before you conduct short selling. The broker must approve you for it, and you must meet the minimum collateral requirement, which is typically $2,000 or 50 percent (whichever is higher) of the shorted stock’s market value. If the stock generates dividends, those dividends are paid to the stock’s owner, not to the person who borrows to go short. Check with your broker for complete details.

Because going short on stocks has greater risks than going long, beginning investors should avoid shorting stocks until they become more seasoned.

What happens when stock prices increase

Say that you were wrong about DOA and that the stock price rises from the ashes as it goes from $50 to $87. You still have to return the 100 shares you borrowed. With the stock’s price at $87, that means you have to buy the stock for $8,700 (100 shares at the new, higher price of $87). The additional $3,700 ($8,700 less the original $5,000) comes from your pocket!

There’s no limit to how much you can lose. That’s why going short can be riskier than going long. When going long, the most you can lose is 100 percent of your money. When you go short, however, you can lose more than 100 percent of the money you invest.

Because the potential for loss is unlimited when you short a stock, you should use a stop order (also called a buy-stop order) to minimize the damage. Make it a good-til-canceled (GTC) order. You can set the stop order at a given price, and if the stock hits that price, you buy the stock back so that you can return it to its owner before the price rises even higher.

The squeeze on short sales

If you go short on a stock, you have to buy that stock back sooner or later so that you can return it to its owner. What happens when a lot of people are short on a particular stock and its price starts to rise? All those short sellers are scrambling to buy the stock back so that they can close their transactions before they lose too much money.

This mass buying quickens the pace of the stock’s ascent and puts a squeeze (called a short squeeze) on the investors who’ve been shorting the stock.

Your broker can borrow stock from another client so that you can go short on it. What happens when that client wants to sell the stock in her account — the stock that you borrowed and which is therefore no longer in her account? When that happens, your broker asks you to return the borrowed stock. You have to buy the stock back at the current price.

Going short can be a great maneuver in a declining (bear) market, but it can be brutal if the stock price goes up. If you’re a beginner, stay away from short selling until you have enough experience (and money) to risk it.