Short Selling Definition
The short sale of stock is a bet that the price of that stock will decline. Here are the mechanics. You decide that XYZ at a price of $110 is at or near its peak. You feel that XYZ will decline in price from this level. So you want to short the stock. You tell your broker you want to short 100 shares of XYZ at 110. You borrow from your broker 100 shares of XYZ at $110 and sell it to someone else.
This is the nature of the short sale. You're selling something which you borrowed. Again, you borrowed 100 shares of XYZ at $110 and sold it to someone else. You actually borrowed the 100 shares of XYZ from your stockbroker. He either has it in inventory or he borrowed it from a client or another brokerage firm. Either way, it is your broker who loans you the stock to sell to someone else.
So now what happens. Hopefully, the price of XYZ goes down for you. Let's say that XYZ declines to $85. At 85, you decide that XYZ may not decline much further, if at all. So you want to take your profits. How do you do that? You now buy 100 shares of XYZ at $85 and pay your broker back the 100 shares of XYZ. You borrowed the stock at 110 and paid it back at 85. You made $25 per share in profit or $2,500. You sold the borrowed stock for $11,000 and bought it back for $8,500.
Conversely, suppose the price of XYZ goes up to $125. The investor would have sold the stock for $11,000 and now might want to get out of the position. He would now have to go into the market and buy 100 shares of XYZ for $12,500. He would then be returning the loaned stock at $12,500. In this case, he has a loss of $1,250.
The potential loss on the short sale of stock is unlimited. This is because a stock can theoretically rise infinitely. Therefore, to protect himself, the short seller should always use a 'buy stop' order GTC (Good Till Canceled). The investor might decide that if the price of XYZ rises $5 he wants to get out of the position. He would place a buy stop order at $115. Then, if the price of XYZ rises to 115, he is assured that he will get out at about 115. Remember, a stop order becomes a market order when hit. Therefore, there is no guarantee that he will get out exactly at 115. But he will get out at 115 or about 115. One can also place a limit order when he wants to get out of a short position which went up. This will get him out at exactly that price. However, there is no guarantee that the trader will get out. He could miss the market.
You may also want to get out of a short trade when you have hit a certain amount of profit. In this case, the investor would use a buy stop at his maximum loss level and a buy stop at his profit target level. This is called an either/or order. You are placing two orders to protect you if the stock rises and to take profit if the stock declines. By the way, this either/or type of order can also be used when buying stock. You can protect yourself against a loss if the price declines and also to take profits when the stock rises.
For the most part, brokerage firms do not place a time limit on the shares of stock they loan. This is because they make a commission both ways. And also, they want to keep the customer happy. Also, you should know that a short sale can only be made on an uptick in that particular security. That is, if you want to short a stock at 110, the short sale can't be made unless the previous trade was at 109-7/8 or lower. Otherwise, in a rapidly declining market, short selling into the decline would aggravate the decline. And remember, the ticker tape is a continuous tape. It doesn't start new every day. So today is a continuation of yesterday. You can't get around the uptick rule by waiting for the next day.
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