Understanding Short Selling

Short selling

Everyone lives by selling something.

Robert Louis Stevenson

This is a term that is used to describe a risky option on the stock market. There are potential gains to be made but there are losses, too. It is not an option for someone new to the investment markets.

The concept

The idea behind the term short selling is to sell stock that you don’t actually own with the hope that the price of the stock is going to drop. Then you would purchase the stock at the lower rate. The difference that you have already sold the stock for and the price that you have paid is the profit that you have made.

Your broker will require you to have an account with them. This will ensure that you have enough funds to pay for the stocks that you have yet to purchase. If the value of the stock falls, then when you instruct your broker to buy the stocks at the lower rate, they will use the money that you have made when you short sold the stock.

If however, the price of the stock starts to rise, then your broker will require you to put more money into the account to cover the potential loss that could occur.

The rules

The only time that you are allowed to ask your broker for a short sell is if the price is rising at the time, because if it was falling then short selling might push the price even lower. The money that you get from the short sell is put in your broker account, but under escrow. This assures the broker that you have the money to buy the shares. If the share prices start to drop like you have predicted, then your broker is happy. But, if the price rises, then the broker might ask you for extra funds because there is going to be a potential loss.

If there is a dividend payment due on the stock that you have short sold, then you will need to pay this money yourself.

The risk

Short selling is a risky option and it should only be attempted by those that actually know what they are doing. It is a good idea that you are fully versed with the stock market for a length of time before even contemplating going down the short selling route.

It has potential to lose big amounts of money, and unless you have the capital with which to pay the difference you might find yourself in a difficult situation. It is important that you know the risks and have the capital to bridge the gap, in case your hunch that the market price on the share price is going to drop and not rise.

Do your homework on the companies that you are considering, know how they are performing and what the potential is for the reduction in the price. If you are unable to answer the basic questions about the company then don’t consider the short selling route, it could cost you more than anticipated.

As with any stock market investment there are always risks, but short selling potentially risks capital that you don’t actually own.