There are many questions about short selling that this stock trading tutorial will attempt to shed some light on. In the most simple terms, short selling is the process of selling shares of stock that you don’t own. In order to sell these shares your broker must “lend” those shares to you in order to fill the order of the person buying the shares. Your brokerage can do that directly (they actually own the shares) or they can do it by arrangement with another institution. When you make a short sale you are predicting that the price of the stock will drop.
Short selling is harder to conceptualize than buying a stock because when you buy a stock you actually own something. When you sell a stock short you are basically promising a certain number of shares to another party. That buyer will actually receive the shares when your short sale is executed. You are then responsible to buy back the shares you sold. If everything goes according to plan, you will be buying those shares back at a lower price than you sold them. This is where the profit comes from.
Margin Account
In order to make short sales you must have a margin account with your broker. You must also be approved for selling short through your broker (these two things are not synonymous). The reason for the tighter restrictions on short sales is because the theoretical risk is unlimited. If you buy a stock your maximum risk is if the stock price drops to zero. You would lose your entire initial investment. When you make a short sale there is no such maximum risk. Theoretically the stock could go to a million dollars tomorrow, and you would be obligated to buy the stock back. It is for these reasons that selling short is only advisable for the most advanced traders.
Put Options
There are other ways to trade the market when you are predicting the price of a stock to drop. One of the most common is to buy put options. This method involves a finite level of risk, and is more suitable for less advanced traders. For more stock trading tidbits visit stocktradingtutorial.org
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