What Is Shorting Stock And What Are The Basics Of How To Do It?

Fundamentals of opening a brokerage account, short-selling stock, and using

You need a securities brokerage account before you can trade stocks, bonds, options or other financial instruments.

There are many reputable discount brokers that will establish an on-line account for you. You can open the account without depositing any funds, but, obviously, you must fund the account before you can trade securities. Normally, a new account must be funded with a minimum of about $1000. Some may let you start with a minimum of $500.

If you don't want to trade on-line, your discount brokerage account is usually also accessible via touch-tone phone, either via automated menu or dealing directly with an account representative. Be aware that on-line commissions are generally the cheapest, with phone commissions being a little higher. You'll pay the highest commissions if you deal directly with a human account representative.

Normally, if you are inexperienced in trading securities, you broker will restrict the type of securities you can trade in your new account. Novice investors are usually only allowed to buy shares of stock, and later sell shares they bought previously.

After the account has been active for awhile, investors must ask their broker, in writing, for permission expand the account's capabilities, such as trading stocks on margin or trading options. It's not likely that many brokers will permit new investors to "short" stocks.

Short selling, or "shorting" a stock, is, simply, selling shares of stock you do not own. It's where you, the investor, have identified a stock whose price you expect will fall. You want to profit from the price decline, so you ask your broker to permit you to sell the stock, even though you don't own any shares of it.

If your broker has granted your permission to sell short in your account, he will either loan you the shares from his portfolio, or he will have to enter the market to see if he can find shares to borrow for you to sell short.

Most likely your short sale will be subject to a time limit, perhaps 30 or 60 days, at the end of which you will have to buy the shares back to repay the loan of the shares you sold short. Buying stock you have previously sold short is called "covering" or "short covering".

Borrowing stock to short is similar to trading stocks on "margin", which is when you put up part, say 50%, of the purchase price, and your broker loans you the other 50 percent. If you "short" stocks, don't be surprised if your broker charges you interest, probably at the same rate as a "margin" trade, on the dollar value of the borrowed shares.

So, for a simple example, if you short 100 shares of XYZ Corporation at $10 per share, your account is credited $1000. Then, if the price declines, as you expect, to, say, $6 per share, you buy the 100 shares and your account is debited $600. You keep the difference, which is $400 (minus your broker's commissions and interest).

But, if you guess wrong and the stock price goes to $14 per share, you are $400 down on this deal. Remember, you may be working under a time limit for replacing the shares you shorted. Let's say your time's up and you must replace the shares at $1400. You must come up with $400, in addition to the $1000 you got when you shorted the stock, to buy the stock back ("cover the short"). In this case, you have lost $400 (plus commissions and/or interest).

Even if you do not have a time limit for covering, you need to decide in advance how long you will stay short if the price goes against you (up). A general rule of successful investors is to bail out of a position if the price goes against you by 5 to 10 percent.

An alternative to selling short is to buy "put" options. "Options" are the right, but not the obligation, to buy or sell a stock at a fixed price, called the "strike" price, before the date the option expires. Buy options are "calls", sell options are "puts".

Options are bought and sold in "contracts". One contract "controls" 100 shares of the associated stock.

Put and call options are not available on all stocks. As a rule, a stock must have a substantial daily trading volume, perhaps 500,000 shares or more, before an options market will develop for it.

You can go two ways with options. If the price of the associated stock moves they way you had hoped, you can instruct your broker to "exercise" the put - sell the stock at the strike price and buy it back at its current price, which is lower than the strike price. If you exercise your put option, you profit on the difference between the strike price of the stock and the price you buy it back at, but you eat what you paid for the put.

Or, you can simply trade options as if you were trading stocks. If you buy a put expecting the price of the associated stock to fall, and it does, then the put will increase in value. You can sell the put at a profit under 2 conditions: It has not expired, and there is a buyer willing to buy it.

Be advised that broker commissions for options are higher than for stocks.

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