How to Short a Stock

Most investors purchase stocks at a low price and they expect their return from an increase in value. However, if investors believe that a stock is overvalued and want to take advantage of an expected decline in price, they may sell the stock short.

A short sale is the sale of a stock that an investor doesn't own with the intent to buy it back later at a lower price. The investor basically borrows the stock from another investor through a broker, sells it in the market and then - hopefully - replaces it at a lower price than the price he had originally sold it. Similarly, the investor who had lent the stock gains the proceeds of the sale as collateral and invests these funds in short-term, risk-free securities. Although a short sale has no time limit, the lender of the shares can decide to sell the shares and the broker should find another investor willing to lend the shares.

Example

We assume that a short seller borrows 100 shares of company X at $10 per share and then sells the shares for $1,000. If the share price falls to $7, the short seller buys back 100 shares for $700, returns the shares to the lender and realizes a profit of $300 ($1000 - $700) minus the fee for having borrowed the shares. However, if the share price rises to $15, the short seller would realize a loss of $500 ($1000 - $1500).

Short selling is a risky exit strategy, typically used by risk-taker investors. Short selling is always the mirror opposite of the market. To achieve effective short sale, investors need to do it at the correct timing, when the price of the share guarantees profits.

Three technical points affect short selling. First, a short sale can be made only on an uptick trade meaning the price of the short sale must be higher than then last trade pride. This is because the exchanges do not favour forced profit from traders on a short sale by pushing the price down through continuously selling short. Therefore, the transaction price for a short sale must be an uptick. For example, we assume the following set of transaction prices: 50, 50.25 and 50.25. The investor could sell the stock at 50.25 even though there is no change from the previous trade of 50.25 because that previous trade of 50.25 was an uptick trade.

The second technical point relates to dividends. The short seller must pay any dividends due to the investor who has lent the stock. The buyer of the short-sale stocks receives the dividend from the company and then he should pay a similar dividend to the lender.

The third technical point relates to the margin requirements. Short seller must post the same margin as the investor who actually owns the stock. The margin can be in any unrestricted securities owned by the short seller.