Understanding short selling stocks

What can an investor do when markets are declining? Aside from selling the stocks you own and holding cash, is there another strategy available when the stock market is going down?

A technique known as short selling allows you to potentially profit from a drop in the price of a security — but how is that possible? Imagine that you believe a stock is trading at a much higher value than it should be; that it’s overvalued. You think it’s unlikely to trade at these lofty levels forever and the price will eventually fall. With this belief, you could wait for the stock’s price to drop to a level that you determine is more reasonable to purchase at, or you could attempt to gain from that anticipated drop by short selling.

To short sell a stock, you ask your broker — in this case, Investor’s Edge — to lend the stock to you. This happens automatically when you enter an order for a short sale — the stock is lent to you and you can sell it from your account as you would sell any other stock holding. In order to make a short sale, you must have a margin account with enough assets to pledge as collateral for the borrowed securities. When the sale is complete, the proceeds — cash — are credited to your short account, but funds remaining in the account are not available to you until you close the short position.

Note: Short sales are not permitted in cash accounts or registered plan accounts, and not all stocks are available for short selling.

You’ve just sold something you don’t own and at some point, you’ll have to return that stock to the lender. You can take the initiative to close this trade when you believe it’s appropriate, or the lender can come to you and ask for it back at any time without prior notice.

In either case, you must come up with the stock and cover the short position by purchasing it in the market. At that moment, the price might be lower than where you sold it short. You buy the stock and keep the difference between what you originally sold it for and what you’re now paying to buy it. You’ve just made a profit.

With a short sale there’s a ceiling on your potential profit, but there’s no theoretical limit to the losses you can suffer. If the stock price drops to zero, you get to keep all of the proceeds of your short sell. However, if the stock price skyrockets, the potential loss is unlimited. This is a risk with short selling, as stocks can sometimes rise dramatically and unexpectedly on positive news such as a takeover. This substantial risk should always be kept in mind when engaging in short selling a stock. 

Additionally, there may be costs associated with short selling. If you short sell a stock that pays a dividend, you’ll be obliged to pay that dividend to the lender until you close your short position.

When you sell a security short, the proceeds of the sale are added to the cash balance in your short  account as a positive value. The funds may not be available to you until you close the short position, unless you have other sufficient collateral assets in the account. Meanwhile the market value of the short position appears as a negative value. That negative value is subject to interest charges as long as the short position exists.

The market value of that negative short position changes as the market price goes up and down, but the cash proceeds stay the same. In order to ensure there is enough cash or other marginable assets in the account to cover the short position, plus a “cushion” based on the short security’s margin requirements, Investor’s Edge performs a daily mark-to-market calculation, and restricts collateral securities and cash within your margin account as required.

Let’s take a look at some scenarios that illustrate how short selling can result in a profit or a loss.

You borrow 100 shares of a stock with a current market price of $10 and sell them for a total of $1,000. You’re now “short” 100 shares. Your profit or loss depends on the price of those 100 shares when you buy them back.