Selling short stocks is an advanced trading technique that runs counter to the goal of most investors. The aims are to find the best stock to buy and look for the best stock to sell.
Short sellers sell stock they don’t own with the belief it will fall in price in the near future. When the price drops, they can buy the stock at the lower price and pocket the profit.
According to thebalance.com, you need to know how short selling works.
How Short Selling Works
If the stock falls the way you predicted, you can buy 300 shares at the lower price and replace the borrowed shares. The difference between what you sold the stock for and what you bought it for is your profit.
For instance, you short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold.
Then, your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 – $10,500 = $3,000). I have ignored commissions and so on to keep the math simple.
If the rise in the stock price had been considerably worse, where the net liquidation value of your account falls below your broker’s margin rules, you will have to deposit more money or cover the short by buying the stock.
Otherwise, the broker will buy in the stock for you to protect themselves against losses that would occur if your account went negative, and you declared bankruptcy.
The Risks in Short Selling Stocks
As you can see, short selling can offer quick profits, but also high risks. Some of the risks are:
- You don’t fully control a short sale. Under adverse conditions, where the stock price rises dramatically, the broker can force you to put up more money, or forcibly buy in the stock without your consent.
- If the price rises, you can lose money. If it weren’t for the broker’s margin desk, losses would potentially be unlimited. Moreover, a large number of short sellers try to cover their positions in a stock, it can drive up the price even faster. This is a short squeeze.
- If a stock is hard to borrow, those short may have to pay interest to borrow the stock, in addition to any dividends the stock pays.
