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What Is Short Selling Explained – Definition, Rules & How to Short a Stock

By Mark Cussen

short selling graphYou don’t have to be a high-level investor to know the basic rule of investing in the stock market: buy low and sell high. But while the rule sounds simple, it’s not always easy or even possible, like when a stock is trading at an all-time high.

If you’re an inexperienced investor, you’ll kick yourself at this point and wonder why you didn’t load up on shares back when they were trading for a fraction of their current price. But you’re not out of luck. Savvy investors have another tool for profiting from high security prices. The key is understanding the difference between buying (long) and selling (short) stocks.

Beginners are used to the idea of a long sale – it’s when you own shares of a stock and sell the stocks later on. However, advanced investors can also consider the option of selling short. While going long in a stock denotes ownership of the shares, going short allows you to borrow high-priced shares from a broker and sell them. When the stock price falls, you buy the shares back at the lower rate and return them to the broker who lent them to you. The difference in price is your gain. Essentially, you reverse the order of the basic transaction and profit from the decrease in value.

Why Sell Short?

Short selling is often your chance to make a profit even though you missed the chance to buy low. If a stock is trading at or near its 52-week high and your research leads you to believe that the price has peaked, selling short lets you make a profit by “buying high and selling low.”

In specific situations, short selling can also help you out on taxes or for stocks tied up in a trust. If you’re not allowed to liquidate shares of a certain stock that you hold in a trust, you can technically borrow the shares from your trust, sell them short, and profit from the falling price without violating the rules of the trust. This technique is called shorting against the box, and it requires a broker to hold the shares as collateral, which will come with some fees. If the price doesn’t fall to the set price for your position, the broker keeps the shares.

Short Selling Rules

Of course, the luxury of being able to sell short comes with restrictions:

  1. You need permission to access margin trading, which requires a level of sophistication, and some paperwork. Brokers like OptionsXpress offer margin accounts.
  2. Since you’re initially borrowing the shares to sell them, your broker can charge interest on the loan, which will cut into your profits.
  3. You’re only allowed to place short sell orders when the stock price is on its way up or isn’t changing. You can’t short a stock while its price is falling.
  4. Securities that you hold as part of an IRA account or other qualified or tax-deferred account aren’t eligible for short positions.

Risks of Selling Short

Of course, the biggest drawback to short selling is that the price might not fall as much as you thought it would, or it may not fall at all. If the price does keep rising, you’ll realize a capital loss, just as you would if you bought a stock conventionally and then had to sell it for a lower price.

Therefore, smart short sellers often place a trailing buy stop order on the position to limit the possible loss. A buy stop order will trigger your account to acquire the necessary shares to fill your short position before your losses can become any larger. Without such a mechanism in place, the price of a stock can continue to rise and lead to devastating losses. Since there’s no limit as to how high a stock can go up (versus going to zero on the way down), potential losses are infinite.

Final Word

When you miss the chance to buy low and sell high, selling short is a great way to turn transactions upside down and find a new chance to make a profit. But just because you can buy high and sell low doesn’t mean you’ve found a loophole in the market.

These moves are not for beginners, and before you get started, make sure you know the rules of margin accounting. Your next steps are to talk with your broker to find out the specific rules you’ll have to deal with for short selling and what you’ll need to do to qualify for margin trading.

Once you’re properly prepared, share your success stories. What short positions have been your biggest victories? Or have you taken a bad loss?

(photo credit: Shutterstock)

Mark Cussen
Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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