Buying a stock you think is going to increase in value is pretty straightforward. But let’s say you think the share price is headed downward. You might still be able to make money by selling the stock short, but this raises a number of issues. For instance, if the company pays a dividend while you are short on its stock, you should know what happens to that dividend money.
Selling Stock Short
In a short sale, you make an agreement to sell shares of a stock to a buyer and deliver the shares at some time in the future. Usually the buyer is your broker. You don’t buy the shares you need ahead of the delivery date. That way, if you’ve guessed correctly and the share price falls, you can buy the stock at less than the market price on the date you made the sale agreement. The buyer has to pay you the higher price and you keep the difference as profit. If you guess wrong and the stock goes up in price, you still have to deliver the shares. In that event, you lose money on the short sale.
Corporations pay dividends only to shareholders of record prior to a deadline called the ex-dividend date. A dividend may be paid while you are short on a stock. However, opening a short sale transaction does not require you to buy any shares. Purchasing shares only happens when you close out the short sale. Since you don’t own the stock, you are not entitled to a dividend.
Securities and Exchange Commission rules require that you borrow shares of a stock you sell short so they are available when you close out the short sale. Failing to borrow the shares you need to meet your commitment to sell is called a naked short sale and is illegal. Normally your broker loans you the shares or borrows them on your behalf. If a dividend is paid on the borrowed shares while you have them, you must send the money to the owner of the shares. In practice, your broker takes care of this detail for you.
Selling stock short is a sophisticated tactic, according to brokerage firm Charles Schwab. Because you must borrow shares, you have to open a brokerage account with borrowing privileges, called a margin account. Minimum balances vary by broker but are usually higher than for basic brokerage accounts. For example, as of publication, Charles Schwab requires you to have at least $5,000 in your account to sell stock short. Depending on the price of the shares, you may need more. Short selling is potentially profitable, but it does carry greater risk than simply buying shares of stock.