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Ricochet Trader Frequently asked questions

Can you explain shorting a stock?

When you short sell a stock, your broker will lend the stock to you. The stock will come from the brokerage's own inventory of stock. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

For example, let's say IBM is forecast to decrease in price a lot. You place an order with your broker to sell short the stock. If the broker can borrow the stock from their inventory, then the broker "loans" you the stock and you sell it in the open market just like anything other sale. In the IBM example, let's say you shorted 500 shares of IBM at $100 per share. Your short account is credited $50,000 (minus broker commission). If the stock drops in price and you purchase the shares back at $90 per share, then you pay $45,000 for the stock (plus commission), and the broker returns the shares to the original owner (who never knew they were sold). In this example, you end up with a $5,000 profit (minus total commission). The dangerous part is that IBM could increase in price, to say $110 per share, and you buy them back for $55,000 (plus commission). In this case, you lose $5,000 on the trade.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more. However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security.

Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price

Short selling is another trading tool you can add to your trading toolbox. But note, there is more risk in shorting because, in theory, a stock could rise forever and you could loose a large amount. In the IBM example, if it increased to $1000 per share and you had not covered your short, then it would take $500,000 to buy 500 shares of IBM, and that would be an enormous loss. If you buy IBM at $100 you cannot lose more than what you invested, and that only happens if IBM goes to zero (not likely).