One of the beauties of being an active trader is the ability to make money both when a stock decreases in price as well as when it goes up. Traders can make money when a stock goes down by short selling the stock. Whereas a long trade is a trader betting that the price of a stock will increase, a trader will place a short trade if he thinks the price of a stock is going down.
How Short Selling Works
In a long trade, a trader makes money by buying a stock at a particular price and then selling it at a higher price. For instance, if you buy 100 shares of IBM at $180 and then sell them later in the day at $181, you’ve made a profit of $1 for every share you’ve purchased, for a total profit on the trade of $100 ($1 profit times 100 shares).
A short trade, however, is slightly more complicated. In a short trade, a trader makes money by selling a stock he doesn’t own (by borrowing it from a broker) at a particular price and then buying it back later at a lower price to deliver back to the broker. For instance, if you think the price of IBM is going down instead of up, you would take the following steps to short it:
1. Make sure you are able to borrow the stock from your broker (we’ll cover this more below).
2. Sell the stock that you borrowed to open your short trade.
3. Buy the stock back later to close your short trade (thus returning the borrowed shares to the broker).
So, continuing our example with IBM, let’s say you borrow the stock and sell it at a price of $180. The stock moves down as you expected and you buy the stock back at $179, thus making a profit of $1 per share you sold short for a total profit on the trade of $100 ($1 profit times 100 shares).
How To Borrow A Stock
When you borrow a stock in order to short it, you don’t need to call up that friend who owes you a favor to see if you can borrow their stock. Rather, you borrow shares of stock to short through your broker. Your broker keeps an inventory of shares of stock for you to borrow, which include most of the listed stocks on the major exchanges. There are, however, some stocks whose shares are difficult to borrow for short selling. These stocks are known as “hard to borrow” stocks.
Hard To Borrow Stocks
Some stocks, typically by virtue of the fact that they have a low float or are heavily targeted by short sellers, have shares that are hard to borrow as the demand for shares to borrow is greater than the supply of shares available. There are two possibilities facing you if you want to short a hard to borrow stock:
1. The stock will have shares available to borrow but you’ll will have to pay a “locate fee” to borrow the stock. The locate fee is usually expressed on a per-share basis and must be paid every day for positions held multiple days. The locate fee can and does change depending on the supply and demand of shares available to borrow.
2. The stock won’t have any shares available to borrow, and thus you’ll be unable to short the stock. Shorting a stock without locating shares to borrow (otherwise known as “naked shorting”) is prohibited by the SEC.
In order to short stocks, it’s necessary to have a margin account with your broker as opposed to a cash account. Under Regulation T, a Federal Reserve Board Regulation that governs how much credit brokers can extend to their customers, you’re required to hold 150% of the cash value of a short position in your account. For instance, if you short 100 shares of a stock at $100 for a total short position of $10,000, you’d be required to have at least $15,000 in your brokerage account. For more information on setting up a margin account and the margin requirements of short positions, be sure to check with your broker.
Other Shorting Restrictions
There are some other shorting restrictions you should be aware of. There is typically a period of time after a stock opens for trade via an initial public offering (IPO) where traders will be unable to short the stock. Remember that in order for you to short a stock, your broker must have an inventory of shares available to lend to you which takes time to build in the case of an IPO. Also, your broker may have restrictions on shorting stocks under a certain price as shorting penny stocks is perceived to be especially risky. Be sure to consult with your broker so you understand the rules and regulations that will apply to your short selling before placing any short trades.
While shorting stocks may seem complicated at first glance, it really becomes quite easy with practice. Remember that a short trade is a bet that a stock’s price will go down, and you must always borrow shares from your broker to sell short a stock. Then, to close the short trade and lock in your profit or loss, you buy back the shares. Now that you know how to short a stock, be sure to start small when placing your first few short trades until you’re confident that you understand the entire process. Adding short selling to your trading arsenal can allow you to profit from both bull and bear markets and improve your returns!
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