What Is a Short Sale?

Tuesday, 21 Dec 2010 03:01 PM

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Stock Market
The stock market is where stocks are issued and the issued stocks are traded or bought and sold. Stocks are exchanged for capital by businesses. Hence, by buying stocks, you become a co-owner of the business. When you need the money invested in stocks, you can sell the stocks. You can opt to trade the stocks directly or through a broker. 
 
Generally, you trade through a broker. The latter charges a certain fee and you have to open an account with the broker for the purpose. This could be a cash account or a margin account. Under the cash account, you have to pay the cash in full while purchasing the stock. Under the margin account, the broker will lend part of the money you need to purchase the stock. The rest is to be brought in by you. This is called margin or margin requirement. The stock will act as collateral or security for the money the broker lent to you. 
 
Short Selling
You can sell stocks that you do not own, unbelievable though it may sound. It is called short selling or shorting. Stocks are allowed to be lent and borrowed for the purpose. This is called security or stock lending and borrowing (SLB). While short selling or shorting the stocks, you ask the broker to borrow the stocks and sell them on your behalf.  The broker may provide the stocks from his own inventory or borrow them from another client of his or another brokerage. After selling the stocks, the broker credits the proceeds to your account with him. When the stocks are to be returned to the lender, you buy the stocks from the market and return them to the broker.
 
By shorting, you hope to initially sell the borrowed stocks at a higher price, and when the stocks are to be returned subsequently, you hope to buy them from the market at a lower price. The difference between the two prices represents your profit. However, if the price of the stock goes up when you buy them, you incur a loss. Lending and borrowing stocks is possible only in respect of stocks approved for the purpose by the Securities & Exchange Commission (SEC).  For example, in September 2008, the SEC prohibited short selling in the stocks of 799 financial companies for three weeks. You can hold a short position for as long as you want. However, interest is charged to your margin account with the broker. So you should not remain short longer than necessary.
 
Under the SEC’s lending and borrowing norms, to sell short, your broker should confirm that he would be able to deliver the shorted stocks. Brokers generally borrow from custody banks and fund management companies on behalf of their clients. If the client has a margin account with the broker, the norms allow the broker to borrow the client’s stocks without obtaining the client’s prior permission. However, SEC norms make it almost impossible for the broker to borrow stocks from clients who have cash accounts.
 
It must be mentioned here that short sale should be undertaken only by experienced investors because it is risky.

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