There are many ways to make money in the stock market, and you don't always have to bet that a stock's value will rise. Short selling is selling a stock that you don't own, and it's one way to bet that a stock's price will decline. Because falling prices have a way of panicking investors, rules are in place to protect against massive declines in value. Among these rules is the short sale exempt rule.
How Short Sales Work
Selling a stock short begins when your broker loans you the amount of stock you want to sell. The goal is that the stock will fall in value, and you make a profit when you buy the stock back at a lower price. Instead of buying low and then selling high, you sell highm then buy low. For example, you begin by short selling a stock at $10 per share now, then buy it back in a month's time at $8, making $2 per share on the trade. However, if the share price rises -- say, to $12 -- then you lose $2 per share on the trade.
The Uptick Rule
Because panicked short selling can quickly send the price of a stock down, the Securities and Exchange commission implemented the short sale exempt rule, commonly called the uptick rule. The uptick rule states that investors can only short a stock when the price is rising -- in other words, on an uptick. The SEC believes that the uptick rule reduces price volatility, but it eliminated the uptick rule in 2007 (with a brief reinstatement in 2008). The uptick rule can slow the decline of a company's stock by eliminating the number of short sellers in the market.
Selecting Stocks to Short
Not every stock can be sold short on a down tick -- or falling price -- however. If the price of a stock trades lower than 10 percent of the previous day's value, then short selling that stock on a down tick is not allowed for that day and the following day. If a stock is allowed to trade as a short sale on a down tick, then it's short sale exempt. What stocks are and are not exempt from this rule are different every day. You won't have to manage the up and down ticks yourself; your account custodian or prime broker will administer this rule on your behalf. If you put in a short sale order and it isn't filled, chances are it's a result of implementation of of the short sale exempt rule.
Risks of Selling Short
Selling short isn't for the faint of heart. You must be prepared to owe money if the trade doesn't go your way. You should also be prepared to have a lot of unfilled orders. There are other ways to bet on price declines, however. Options and derivatives are frequently used strategies that accomplish this approach. However, all investments have measurable risk, so before you proceed with selling short, make sure you consider your options carefully.
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