Short Stock

An advisory service would usually recommend shorting a stock (that is, selling it with the intention of buying it back for less later) when they expect the price of that stock to go down.

In the following example, Cisco Systems is trading at $26.94. There is a downturn in the IT sector that is expected to flow through to Cisco's bottom line. To take advantage of the expected fall in the share price, your advisor recommends shorting 500 Cisco shares.

:: Trading Condition

Stock	CSCO
Price	$26.94
Outlook	Near term bearish

:: Alert Example

Action	Sell 500 shares
Limit	$26.75
Stop	$30.00

:: Margin

In order to short stocks you need to have a margin enabled account. Margin requirements vary from broker to broker, though the one we use is that enforced by optionsXpress - 50% of the short value of the shares and a $5/share requirement on stock costing below $10/share. In our example, then, we would need to have at least $6,687.50 in our brokerage account as margin. And if the shares were valued at $5.00 or less, we would not be able to short them (that is the consequence of the $5/share requirement on stocks below $10). As margin is money you have borrowed from your broker, you will also pay interest on it.

:: Borrowing Stock

For you to be able to sell stock you don't own you need to get it from somewhere, and you do this by "borrowing" it from someone who owns it (often without their knowledge). This could be your broker, one of your broker's clients, the client of another broking firm or a large institution. If the shares aren't available to be borrowed, you can't complete the transaction, which is why liquidity is an important aspect of this strategy.

:: Uptick Rule

You cannot short stocks into a falling market - this is done so that short sellers don't create a market where they are the primary influence. To prevent this, most exchanges have rules that determine when you can and cannot short, and these are called "uptick rules" - a short sale can only happen after an uptick (a rise in the share's price) or a zero plus tick (where the last sale is the same as the previous sale but higher than the previous different sale).

:: Profit & Loss

Assuming all the above factors are in position and you do get to place your short order, you would have "borrowed and sold short 500 CSCO shares @ $26.94". If your advisor is correct and the technology sector does fall (to $23.49, for example) you would then have the opportunity to profit from the transaction by "buying back and returning 500 CSCO shares @ $23.49". The difference between the two amounts is your profit:

($26.94 - $23.49) x 500 = $1,725.00

And the reverse is also true. If the share price rises you will first be subject to a margin maintenance call whereby your broker will require you to deposit more funds into your account. Maintenance rates vary but optionsXpress set it at 40% of the short value (slightly less than the 50% needed to open the position).

Then you may need to "cover" your short position by buying back the shares for more than what you sold them, in which case you will make a loss. Theoretically, the possible loss on a short position is infinite given that the share price could continue to rise indefinitely, but in reality this is not case. Nevertheless, the potential for significant loss is there.

:: Called Away

One scenario whereby losses can be incurred in short selling is by being "called away". In shorting stock you're employing an asset that someone else owns - remember, you've borrowed it. If the original owner decides they need the shares (to sell them, for example) they will need to be replaced by your brokerage firm. If replacements can't be found you will have to replace them, even if that means going to the market and buying them for more than what you sold them for. In this way, the shares are "called away" from you.

:: Short Squeeze

Another loss scenario could come about through a "short squeeze". This occurs when there is sudden demand for a stock which has a large number shares outstanding on the short side. As the buying increases, it forces those short the stock to cover their positions (that is, to buy the stock themselves) which only intensifies the buying.

:: Days To Cover

One way to avoid a short squeeze is to make sure that any stocks you short have a relatively low (7-8) days to cover. This is calculated by dividing the number of shares that have been sold short (its "short interest") by the average daily trading volume. If the former is 500,000 and the latter is 50,000, then the days to cover will be 10. A short days to cover means that any short interest can be quickly eliminated if the price starts to rise, thereby preventing a short squeeze from working.

:: Dividend Payment

One final point to remember when shorting stocks is the dividend payment - if it occurs while you are short, then you will have to pay the original owner of the stock the dividend out of your pocket. The company will pay the dividend to the new owner (the one who bought them off you) but the old owner (the one from whom you borrowed the shares) will also expect a dividend payment. As the company certainly won't pay twice, the second payment comes from you. Consider it the cost of shorting.