Shorting a Stock

Shorting a stock, or short selling, means to sell a stock which you do not actually have ownership of so you may profit from its potential decline in price. The shares of the stock are borrowed by your broker and then sold in the open market. The resulting funds are deposited in your account. The hope is that you can by them back later at a lower price in order to return them to their rightful owner. When successful, this will allow you to pocket the difference in price as a profit. In order to do this, you must have a margin account with your broker and your broker must have the shares available to loan to you. The number of shares you can borrow is based on the cash already in your account.

At first glance, the act of shorting a stock does not appear to be much more complex than simply the reverse of buying a stock. However, before you run out and start shorting stocks, let's look at what else is involved and why shorting stocks is generally considered more risky than going long. You should also keep in mind that shorting stocks involves potentially unlimited risk. This is because stocks can go higher with no limit and if you are short the shares, you are on the hook. By contrast, when going long, a stock can "only" go to zero.

As you will see by reading this text, there are a number of differences between shorting stocks and buying stocks that you should be very aware of. Interestingly, each of these differences, when taken separately, does not seem all that important. However, when combined together, they can and do increase the risks associated with shorting a stock; this is especially true should things turn against you in the market.

Let's continue by examining some of the more important factors to keep in mind when considering short selling:

WHERE DO YOU BORROW STOCK FROM - One of the first questions that comes to mind when talking about shorting stocks (i.e. selling borrowed stock to reap a profit by buying it back at a lower price) is where does the initial stock actually come from? This is a good question and one that often times comes into play when attempting to short a stock in the first place.

The fact is, you have to be able to borrow the shares to begin with to short a stock; sometimes this is actually not always possible. When you place an order to short a specific stock, a search is made to find available shares in the market. Interestingly enough, shares are borrowed from other investors' accounts without the knowledge of the original stock holder. Firms usually search their own accounts first, then the accounts of larger firms in an effort to find shares to short. The larger the firm you deal with, the more luck you may have shorting the stock you want.

Shorting shares of IBM, MMM or GE may not be much of a feat, since stock is generally readily available in many accounts across the country for these types of larger companies. When a stock is widely held and quite liquid, more than likely shares are available at the brokerage firm where you are placing your order. However, should you suddenly try to short shares in a stock which is more thinly traded or which is not as widely held, you may run into more difficulty. In fact, often times you simply cannot short certain stocks because no shares can be found to borrow (note: sometimes providing your brokerage firm with 24 hours notice on the stock(s) you wish to short can help matters).

However, assuming there are shares available, your firm will borrow the shares and allow you to sell them in the open market. The resulting sale will leave you "short the stock" and you will have the profits from the sale deposited into your account just as with any other sale of stock.

As mentioned, you must have funds in your account in the first place in order to short stocks - just as you would in order to purchase a stock. In other words, you cannot wake up tomorrow morning and suddenly short 5 million shares of stock in CSCO without having an equal amount of money to back up the sale.

THE CATCH - The main stipulation here when shorting a stock is that should those original shares suddenly be called upon by the original owner (for example, to be sold), they must immediately be returned and/or covered by the firm loaning out the shares (and that means you really). If replacement shares are not available, or a shortage in the shares occurs, you may be faced with having the stock "called away" from you. When this happens, the only recourse you may have is to buy the stock [immediately] in the open market - regardless of price. As you may be starting to see, shorting has aspects not normally associated with buying stocks.

OTHER STOCKS YOU CANNOT SHORT - Aside from being unable to locate shares to short in the first place, there are other cases in which you may find that you cannot short a stock. Generally speaking, you cannot short most IPO's, nor can you short stocks under $5 (however, as an interesting side note, I believe in Canada you can short stocks of any price). Typically, it's best to call ahead and make sure there are shares available to short in the stock you are interested in and that it meets all shorting guidelines for the brokerage firm you are using.