How Does Shorting a Share Work?

by Rose Johnson

Bullish investors profit from buying stocks at a low price and selling them for a higher price. Investors may also make money when they are bearish and believe the stock market or a particular share will decline in value in the future. Investors who short shares of a stock never own the stock, but borrow the shares for a specific time period. Shorting shares of a stock requires an understanding of how to value stocks and trade on margin. Shorting a stock can lead to substantial profits for experienced investors, but it can lead to substantial losses for investors who lack sufficient knowledge and experience.

Borrowing Stock

Short-selling involves borrowing shares from a broker and selling the shares on the open market. The investor speculates that the price of the stock will decline, and attempts to buy the stock at a lower price in the future. Once the investor buys the stock back at a lower cost, the shares are returned to the original owner. The difference between the price the investor sold the shares for on the open market and the price paid for the shares at a later date is the investor’s profit. Investors are required to own a margin account to short shares. Margin accounts allow investors to borrow money to trade stocks. Brokerage firms monitor investors’ margin accounts closely to verify that they can pay their financial obligations.

Margin Account Requirements

Brokerage firms implement strict requirements and restrictions for investors with margin accounts that desire to short-sell shares of stock. The specific requirements of a margin account vary per broker. In most cases, a brokerage firm requires an investor to place into his margin account money equaling a certain percentage of the market value of the shares he desires to short-sell. The cash placed in a margin account acts as collateral for borrowing the shares and is off limits to the investor. Brokers also charge investors a maintenance fee — which is usually a percentage of the current value of the stock — while the trade is active.

Benefits

The primary benefit of shorting a share is that it allows you to profit from a decline in the stock market. Another benefit is that short-selling allows you to hedge your losses. If short-selling stocks is a part of a diversified portfolio, when some of your stocks decrease in value during a bear market, the shares you short increase in value. Hedging your portfolio limits your risks and losses. The potential profits of shorting a stock are amplified because investors use leverage to short shares. Leverage essentially means that the investor is using the brokerage firm’s money to execute trades, which allows investors to profit from money they do not possess.

Risks

Short-selling a share involves taking serious risks. When you own a stock, the most money you can lose is the amount of your original investment if the stock price falls to zero. No limit exists for how high a stock price can rise, which means your losses are unlimited. The higher the price of the stock rises, the more money you lose when short-selling the stock. Another risk of short-selling a stock is the obligation to pay dividends to the owner of the stock if the company decides to pay a dividend when the shares are in your possession. The money to pay the dividend is taken directly from your margin account. If you are shorting thousands of shares, this can result in substantial losses.

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