What is a Short Sale

I can not count the number of times a neophyte investor has asked the question, “What is a short sale?” People have a very hard time understanding how someone can sell something that they do not own. In fact that is exactly what a short sale is: the borrowing of a stock and selling it to another investor as if it was your own. Indeed, the true owner of the stock will never know that someone has borrowed their holding and sold it. The brokerage firm will simply borrow the stock from the equities in their care.

When an investor sells a stock short they are hoping to make a profit by repurchasing the shares at a lower price. Let’s assume an investor shorted 100 shares of MSFT at $30 per share. From that sale they would receive $3,000 ($30 x 100 Shares). If MSFT then traded at $25 the investor could repurchase the stock for $2,500 and return the borrowed shares. This trade would net $500 from the short sale. On the other hand if the market price of MSFT went up the investor would spend more to repurchase the shares and it would be a losing trade.

A short sale is one of the more risky investments, if you can call it an investment, than an investor can make. When an investor shorts a stock they are literally taking on unlimited risk. The price of a security has no ceiling and every now and then investors do get burned. Could you imagine shorting GOOG when the IPO was originally issued? If an investor did short GOOG they would have lost much more than the original investment as the price has more than tripled.

An investor whom shorts a stock has to do so in a margin account. This will ensure that the investor will eventually buy the stock back and return it to its rightful owner. If the shorted stock was to unexpectedly rise in value a margin call could be issued. When a margin call is issued the investor must deposit funds or the short position will automatically be closed.

Dividends are another issue an investor has to deal with when they short a stock. The original owner still owns the stock and so does the person that you sold the stock too. As this is the case when dividends are issued both parties are entitled to receive them. The short seller is personally responsible to pay the dividend to the original owner.

Short sales are an investment that I really can not recommend. Over the long term the trend in the market has been and should always be up. Sure periods will exists where an investor can profit from shorting an index but over the long haul they will lose. Some investors will short individual stock and proclaim success. In my opinion this is nothing more than gambling.