Short Sale Basics
Research for Online Investors

This article originally appeared in MarketToday on 1/13/10

by John Dalt

Our SwingTrader subscribers enter trades to make small incremental gains on the market, whatever the trend may be.  Sometimes this involves “shorting” a stock.  What does “selling short” mean and how do we do it?

We normally buy stocks that we think are going to appreciate in value.   When they go higher we sell them and pocket the difference in gains.  Buy for $20 Sell for $22 = $2 profit.

Occasionally, we see a stock and think, "That stock cannot go any higher, it has to pull back."  When we expect a stock to go down we can reverse the process.  Sell for $22, Buy for $20 = $2 profit.

How do we do it?  You must have a “margin account” to have short selling enabled.  That is, you must be able to borrow money from the broker.  You enter a symbol, quantity, limit price and process the order to “Sell Short”   This notifies the broker that you want to ‘borrow’ shares of the stock and sell them.  The broker borrows the shares from another customer and places an IOU in his account.   The other customer never knows this occurs as he has given permission in advance for the broker to borrow stock from his account.

We like to use limit prices that are higher than the market price.  The idea is not to play the momentum of a stock falling, but to catch it on its high of the day, before it starts to fall.  When XYZ company reaches our limit price, the sell order is triggered and we now show a negative number of shares in our account.  The position may also be in red on your computer screen, depending on your trading platform.

For a profitable trade, the XYZ stock must go down in price.  When you are ready to close the trade, you enter the symbol, quantity and order type (market or limit).  Use ‘Buy to Cover’ to enter this order.  You are “covering the short”, and closing the trade.  You either gain or lose the difference in price between the open and the closing price.

A few points on “short selling”

• Your broker may not always have stocks available for you to short.   If no stock is available, your order will be rejected. 
• Your account may be charged interest on the value of the short position.  Brokers have different policies. 
• If the company you shorted goes bankrupt and the stock is delisted, you may not have to close the transaction, which means you don’t have to pay taxes on the gain! 

Cautions on Selling Short.  If the stock goes up, your potential loss is virtually unlimited.  This is explained simply because stock prices can only go to zero when you are long a stock, so your potential loss is only 100% of your investment.  A shorted stock can continue to go higher and higher.  You can lose much more than the original price of the stock.  The corollary is also true; you can only make profit equal to the value of the stock.   Your potential profit is limited in that the price cannot go negative.

While you are short a stock you must pay any dividends to the original owner of the stock.  Always check the dividend history of a stock before deciding to enter a short sale.  This can catch even experienced investors.  One of the real dangers is a ‘special dividend’ that is declared without warning.   Special dividend announcements can cause a stock price to spike making it hard to close the trade profitably.

I hope this has helped you understand “short selling”.  If you have questions or comments, please send them to feedback@galtstock.com

The information presented in this article is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

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