Shorting a Stock

THE UPTICK RULE FOR SELLING - Assuming you find shares to short, there are certain rules which control the sale of the stock depending on which exchange it trades upon. Generally speaking, you cannot sell a stock into a falling market. This is where the "uptick" rule comes into play.

As you can probably imagine, this is done to help keep short sellers from causing a sliding market where nothing but selling is taking place. Normal selling is viewed one way in the market, while short selling is viewed somewhat differently.

Should you attempt to sell borrowed stock, you may find that you have to wait for what is called an "uptick" in some cases. On the NYSE exchange, this means that a short sale may only be done on an uptick or a zero plus tick - a price that is the same price as the last trade, but higher in price than the previous different trade. On the Nasdaq exchange, you cannot short on the bid side of the market when the current inside bid is lower than the previous inside bid (a down tick). If you are shorting stocks on other exchanges, you'll need to review the rules associated with that exchange or ask your broker to explain what is required for each individual situation. But, in general, you can only short into a rising or stable market. Once the market does up tick, you can then sell your stock at the current bid price offered in the market. The profit resulting from the sale is then deposited into your account.

ADDITIONAL UPSIDE RISKS TO SHORTING - One of the first differences you should note when shorting stocks is the large additional upside risks which are involved. When you buy a stock, the worst that can happen is the stock will go to zero. However, when you short a stock, it can go up forever. This is a very important point to consider before shorting any stock, since the upside risks are basically unlimited (although there are margin requirements that will eventually kick in and result in a margin call).

THE BENEFITS OF SHORTING - Interestingly, there is a benefits to shorting stocks. Typically, and this is only a guideline, stocks tends to fall about twice as fast as they climb. As you know, negative news can bring down a stock very quickly - sometimes wiping out months' worth of gains in a single day or two. From this standpoint, if you do hit a short play correctly, your gains can sometimes be realized in a shorter time period than waiting for a stock to gain ground and move higher.

THE LATENT DEMAND THAT SHORTING CREATES - Another aspect of shorting stocks that you should always keep in mind, and which in some respects increases risk, is the idea of "latent demand". When you short the stock, you actually are building up latent demand for the shares. This is because at some point in the future (unless the company goes out of business) you will have to be a buyer of the stock in order to return the shares to their rightful owner. A wave of short sellers will one day mean a wave of buying.

SHORT SQUEEZE - If you have been trading stocks for any amount of time, you will have probably heard the term "short squeeze". A short squeeze is actually when there is a sudden demand (i.e. buying) in a stock which has a large amount of shares outstanding on the short side. If the buying keeps up and starts to force short players to cover their short positions, the result can be quite sever. Buying increases the share price, which in turn tends to produce additional fear (and short covering) among short-side players in the stock market. As people rush to buy stock and cover their positions, this continue to dizzying heights until a normal supply/demand situation returns to the market. As the old saying goes, "He who sells what isn't his, buys it back or goes to Prison". The bottom line is that if the stock you have borrowed and sold is suddenly required, you may end up being "bought in" whether you like it or not.

SHORT COVERING - Assuming everything goes as planned, then at some point you will cover your short position to complete the trade. In order to complete a short sale, you will need to repurchase and return the borrowed shares of the stock. This is called "covering" your short position and completes the transaction.

Incidentally, when placing your order, you should specifically instruct your broker that you are covering an open short position, otherwise it's possible to end up with both a long and short position in play. Ideally, you'll be covering your short play at a lower price than where you sold the shares and this resulting difference in price will be your profit.

ONE ADDITIONAL CAVEAT - If you are short a stock at the same time as a stock dividend is paid, don't forget that you owe that dividend to the owner of the original stock. Your broker will charge your account for the amount of the dividend owed based on the number of shares you have borrowed. Keep this in mind when shorting dividend-paying stocks.