What is Short Selling Stock?

Did you know you can also profit when a stock price goes down? Short selling stock is the practice of selling stock and profiting when the price goes down. When you short sell a stock, a broker will lend the stock to you. It will come from the brokers own stock portfolio, one of their customers portfolios or from a different broker. Basically, they will sell the stock you want to short from somewhere.

Once you short sell the stock, the broker sells the stock and the value of the sale will be credited to your account.

To effectively close the trade, you need to buy back the stock you sort sold.

If the stock price is lower when you buy the stock back, you earn the difference. If it’s higher you have to pay the difference to the broker.

At no point do you physically own the stock, you just borrow it from your broker.

Confused? here an example

I remember it took me quite a while to get my head around short selling so I will just give you a quick example incase you are getting a bit lost like I did at first.

Let’s say I want to short one share in exxon mobil and the stock price is $50. I think they are going to crash down to $40. If I was short sell a $50 share, my broker would have to sell 1 exxon mobil share which they owned.

If my prediction was correct and the stock did drop to $40 and I close the trade, I would be $10 in profit. However, if the stock rose to $60 I would lose $10.

To close the trade I would buy back the exxon mobil share at the current market price and give it back to my broker.

Naked Short Selling

Naked short selling is where a stock is short sold without the stock physically being sold by a broker or other third party.

This practice has often been used to manipulate stock price. Large amounts of short selling can drive down even the largest of stocks. The use of short selling for this purpose is illegal.

During the banking crisis of 2008, many large traders were short selling many of the major financial stocks, as a result the SEC put a temporary ban on shorting these stocks.

Risks of Short Selling

Short selling stock can be risky as downside risk is unlimited. There is always the risk that the stock you short sell will never drop below the price you sold at.

To minimize the risk you can use stop losses so if a certain price is reached, your broker will automatically close the position for you and realize the loss. A small loss is always better than a large one.

As with all kinds of stock trading, it is important to have a rigid set of trading rules and a great deal of trading discipline.