WHAT IS SHORT SELLING?

WHAT IS SHORT SELLING?

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.


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. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't have, and 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 selling a particular security short.

Since you don't own the stock (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 stock splits during the course of your short, you'll owe twice the number of shares at half the price.

Also, because you are being loaned the stock, you are buying on margin. In fact, you have to open a margin account to short stocks.

EXAMPLE:

BORROWED 100 SHARES AT $10 EACH = $1000(SHORT SELL)
BOUGHT BACK 100 SHARES AT $7 EACH = $700(BUY TO COVER)
PROFIT = $300

BORROWED 100 SHARES AT $10 EACH = $1000(SHORT SELL)
BOUGHT BACK 100 SHARES AT $15 EACH = 1500(BUY TO COVER)
LOSS = $500

The credit for this article goes to www.investopedia.com

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