Short selling stocks means trading borrowed stocks or securities, it is the short sale of a security that the seller does not own but promises to deliver anyway. When you short sell a stock, you must have a broker who lends it to you.
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Short Selling Stocks Meaning
So basically short selling stocks means when the investors sells borrowed stocks at selling price then waits for stock price to go up or down if the stock price falls then the investors buys back stocks at a cheaper price and returns stocks to lender and keeps difference as profit.
Now if the short stocks rises in price the short seller must exit immediately because that means he will have to spend more to buy traded or borrowed stocks in order to payback lender. Some stocks just continue to rise leaving the investor in debt so short selling stocks is a risky business.
There are three options from where you may acquire your short sale stock list:
- Current brokerage firm’s own inventory
- Any other brokerage firm
- Brokerage firm’s customers.
How Do You Short Sell A Stock
So once the shares are successfully sold, the earnings are credited to your account. Remember you can’t short sale a stock without a broker who lends you the shares therefore you must first have an account with your broker.
Eventually, you would have to “close” the short. This is done by buying back the same number of shares and then returning them to your broker who lend you the stocks you sold to begin with. Now in short that’s how to short sell a stock.
Once the price of the stock is lower you make a profit because you bought the stocks back at a lower price. Short sellers lose money when the price of the stock rises because they have to buy it back at a higher price.
Short selling is a valid trading strategy; however, there are two important points that investors must remember:
Short selling carries with it unlimited risk because the purchase price of a security can rise to any price point. Conversely, long investors (buyers) may only lose the amount invested — if, for example, the security price drops to zero.
Short sellers are subject to price manipulation schemes — or short squeezes.
In a short squeeze, traders believing that there are a lot of short sellers begin buying shares to force the price and the short sellers losses higher.
These traders hope that the short sellers will be forced to buy pushing the price even higher at which point they can sell their shares at a profit. Short squeezes are easier to execute in illiquid securities.
Using Brokers To Short Sale
Brokers are necessary if you plan on short selling stocks. When you use a broker, you will need to set up an account with a brokerage firm either in cash or a margin account. With cash accounts, you will be required to pay for your stock along with the purchase.
On the other hand, securing a margin account with the broker allows you to borrow a portion of the funds at the time of your purchase. The security will serve as your collateral.
In essence, the stock you are short selling does not belong to you as you borrowed it before selling it. You must therefore pay any stock lender the dividends or rights declared during the process of the loan.
Therefore, you will owe the lender of the stock twice the number of shares if the stock splits during the course of the loan.