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What is short selling a stock?

Why sell short?

In the world of short selling, an investor is trying to catch a falling star instead of looking for a company on the rise. Short selling is defined as the sale of securities that the seller does not own. In investment terms, selling short means that you believe the market will go down. If you can sell stock that you do not own and replace it by buying the shares at a cheaper price if the market declines, the difference, less commissions, is your profit. If the share price rises, you would have a loss. Because of the risks involved, short selling is not for the faint of heart.

The Ins and Outs of Short Selling

In order to sell stock that you do not own, your investment broker borrows these shares from another client's account, or from its own account, then lends you the shares to sell short. Your request is relayed to the brokerage firm's margin department, then, assuming the stock is available to loan to you, you place a sell order with your broker as you would place any sell order. You will be required to deposit money to your account to maintain an adequate equity level. Depending on which way the stock price subsequently moves, you may have to deposit additional funds. Selling short is very risky and is one area of the market that is still mostly in the hands of professional traders and sophisticated investors. Many financial advisors discourage investors against this speculative, high-risk form of trading. To illustrate the process, we'll use an example with Dave as our short seller.

Example of a Short Sell

Short seller Dave researches XYZ Co. and comes to the conclusion that the current share price of $66.00 is overvalued. He believes that their price will fall to $58 within the next one to three months. If he were to sell 100 shares of XYZ short at $66 and repurchase them in the future at $58, he would earn a profit of $800 before commissions. But -- and herein lies the risk -- what if XYZ Co. shares do not fall and they actually rise to $70, Dave would be facing a potential loss of $400 before commissions.

Risks in Short Selling

Market Unpredictability

First and foremost, in short selling a stock, you are making an investment gamble that a company's share price is going to fall. Despite extensive research and market experience, the stock in question may contradict your prediction and rise.

Maintaining Equity Position

Your investment dealer requires a minimum percentage of equity in your account to maintain a short position. If the shorted stock rises in value, you are required to bring your account's equity position back up to the minimum required. But it doesn't stop there.

Unlimited Risk

Unlike holding a stock through a price decline and only suffering a paper loss until the stock price recovers, short selling can have unlimited consequences.

Example of Unlimited Risk

When you buy a stock, the most you can lose is everything, or 100 per cent. With short selling, you lose 100 per cent when the share price doubles, 200 per cent when the share price triples, and so on. An actual loss is triggered only when the stock is repurchased, but in the mean time, your broker will be calling on you to deposit more money to your account.

Rewards of Short Selling

Successful short sellers feel that exposing a portfolio to some short positions creates greater portfolio diversification. These investors feel short selling takes advantage of market fluctuations. Supporters of short selling use this strategy for the same reason that investors choose to buy a stock for the long term: potential profit.

Doing your homework

Short selling appeals to sophisticated investors who have a high-risk tolerance and are willing to conduct thorough research on a company.