Briefly, the short sale occurs when the seller of a security does not own what is being sold but promises to deliver it anyway. When you enter into the short sale of a stock, it must be loaned to you by a broker. The actual stock may be obtained from the brokerage firm’s inventory, from another brokerage firm, or from another customer at your brokerage.
Once the shares are successfully sold, the earnings are credited to your account. Eventually, you would have to “close” the short. This is done by buying back the same number of shares and then returning them to your broker who lent you the stocks you sold. If the price of the stock is lower you make a profit because you could buy the stock back at a lower price. Short sellers lose money when the price of the stock rises because they have to buy it back at a higher price.
It is necessary to have a broker if your plan includes short selling stocks. In order to use a broker’s services, you will be required to establish an account with the brokerage firm as either a cash account or a margin account. With a cash account, you will be expected to pay for your stock at the time of the purchase. Alternatively, if you have set up a margin account with the broker, you are allowed to borrow a portion of the purchase money. The security itself will collateralize the transaction.
In essence, the stock you are short selling does not belong to you as you borrowed it before selling it. You must therefore pay any stock lender the dividends or rights declared during the process of the loan. Therefore, you will owe the lender of the stock twice the number of shares if the stock splits during the course of the loan.
A short selling stock is something that no beginner should try to do as it involves an understanding of the market and an understanding of greater risk. When you short a stock, there is technically no ceiling on the amount of money you can lose. Contrast this with buying a stock where the most you can lose is everything you paid for it but no more. Many also frown on short selling because you are making a bet that a stock will do poorly which is not a productive action.
categories: investing,stocks,stock market,equities,wealth building,savings