WHAT IS SHORT SELLING AND HOW CAN I BENEFIT FROM IT?

Traditionally people understand investing in stocks in way that you buy an stock and hold it until it rises enough to make a sizable profit, and sell it after that. But what about the times you come across a stock that you wouldn't invest in, and you think that it is only a matter of time when it will collapse? Well you can profit from the decline of a stock and although it sounds easy, the mechanics of a short sale are little complicated and the investor's risks are high so it is important that you understand the transaction before getting into it.

PROCESS OF SHORT SELLING:

First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. Short selling is the selling of a stock that the seller doesn't own, so it’s the sale of a security that isn't owned by the seller, but that is promised to be delivered. 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 position by buying back the same number of shares 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. So the risk is that stock prices can theoretically rise indefinitely but fall down only to zero.

So short selling or "shorting" or "going short" is the practice of selling assets, such as stock, futures, options etc. that have been borrowed from a third party ie. a broker, and buying identical assets back at a later date to return it to whom lend it to you. In other words, you take a "negative" position in the market, because you bought a negative amount of assets. If you short a stock, you expect price to fall to profit form your position, and to be able to buy back the shares you nee to close a position, at a lover price that you paid for. So going short is a contrast of going long.

WHERE DOES BROKER GET THE STOCKS?

Short selling is a marginable transaction. You must open a margin account to sell short. This is the same account you would use if you want to use your stocks as collateral to by stock on margin (more about that in the future posts). The general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction, so if you have $25,000 worth of stock/cash in your margin account, you can borrow $50,000 of stock to sell short.

HOW DO I SELL SHORT?

Short selling, unlike a normal stock transaction where we have buyer and a seller, here we have the original owner, the short seller, and the new buyer. Short seller borrows shares from the original owner, and then sells them on the open market to any willing buyer. To close his position, he (short seller) must buy the same amount of shares as he sold so that the broker can return them to the original owner.

While you have an open short sale position, your broker will charge you overnight interest on the value of the short position. If the stock you shorted goes up or down in price your collateral will be higher or lower, and if it is lower by certain amount you may be required to place more money in your brokerage account, or buy back the stock that you sold short. Also, you must pay any dividends issued by the company whose stock you sold short, because that person is still the real owner of the shares you hold.

WHY SELL SHORT? SPECULATION AND PORTFOLIO PROTECTION:

The two primary reasons for selling short are speculation and and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level, and they believe that the stock price will fall. A short sale provides the opportunity to profit from the overpriced stock.

Another reason is that short sales can protect your portfolio against a market downturn. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling. This is know as a hedging. More about that I'll caver in future posts.