Selling Stock Short Explained
Alright, so you’ve always heard of someone going, “hey, I would short that sucker next week, there is no way it is going up.” You understand the main idea that you are betting a stock will go down, but how does it actually work? Selling short straight forward as is means you are selling stock you do not own to a broker, the broker pays you for those shares, then you buy back those shares (hopefully at a lower price) and pay the broker back. Let’s break it down now.
The short selling process can be broken down like this:
- Finding a stock you think will go down
- Selling shares you do not own to your broker
- Collecting your money
- Watching the stock go down or up
- Buying back the shares you didn’t own
- Keeping the difference, “Change Please!”
Finding the stock that is going to go down the tubes (step 1)
You get a “hot tip” from a friend that google isn’t going to make their earnings estimates, and you decide you want to make money once the stock falls in price. You have margin approval (margin is important here but not vital for the overall concept. I will write on margin soon so you can read up on it I promise!) and the stock is currently trading at $450 a share.
(clicks ’short sell’ button), “Wow, I have $4,500 extra now, cha-ching!” (step 2 and 3)
So you know you want to short google, and you decide to short 10 shares because 10 shares at $450 is $4,500 (10 x $450); I mean come on, who is going to short 9 shares of stock? You go fill out your trade ticket (which I have an actual picture of for all you home gamers directly from my Ameritrade account; see attached) and click the “Sell short” circle, then type in 10 next to “Quantity” then next to “of Symbol” you type goog (google’s ticker). Order type you set to market (which means that it will execute immediately), then click “place order”.
Now what the heck did you just do? Let’s summarize here, you sold short 10 shares of google at the market. You sold short (said, hey ameritrade I am selling you shares I do not own), 10 shares of google (”how much?” 10 shares Ameritrade) at the market (process that ASAP btw). So, right when you click place order, ameritrade GIVES YOU $4,500 for your 10 shares you didnt own (since google was conveniently at $450 a share at the time).
“O Great, Google fell 20% on the bad news today!” (step 4)
Your hot tip was right, and google didn’t meet the expectations it was supposed to, resulting in the stock falling 20% or $90 (.2 x $450) to $360 ($450-$90) a share. What a great deal you have here, and it has to feel pretty cool that you called a stock to drop and now are making money when the stock is going DOWN and not UP! Hats off to you, we should celebrate with a trip to Starbucks after we cover (buy back the shares).
(Clicks ‘Buy to Cover’ Button) “Where did my money go?” (step 5)
You can refer to the attached Ameritrade trade ticket if you so desire, but what happens now is the direct opposite of what you did prior. Instead of hitting sell short, you hit buy to cover because that is exactly what we are going to do, buy to cover (buy the shares back that we don’t own from Ameritrade). We fill in the following: “Buy to cover” circle, under “Quantity” we put in 10, under “Symbol” we put goog, and we fill in “order type” as market so there is no price entry needed.
As soon as we hit “place order” two things happen:
- We literally buy back the 10 shares we did not own, so now Ameritrade doesn’t have fake shares and we don’t owe Ameritrade anything.
- We pay Ameritrade for the shares at the current price, which in this case is $360 a share, so we say, “here is $3,600 ($360 x 10) Ameritrade, have a nice day!”
Keep the difference, nicely done! (step 6)
Since we fulfilled our obligation, and we bought back the 10 shares we sold to Ameritrade for $3,600 dollars ($360 per share x 10). Since we sold them originally to Ameritrade for $4,500 in cash ($450 per share x 10), we then have left over $900 in cash sitting in our account ($4,500 - $3,600) so what the heck? It is ours to keep! The transaction is completed and we get to keep the difference. We successfully sold shares we didn’t own to Ameritrade, then bought the shares back from Ameritrade at a cheaper price. Good work, make sure you let me know about the hot tip next time though!
Ameritrade Trade Ticket Attachment
http://falkininvesting.com/blog/images/trade%20ticket.JPG
Discuss this post in the StockTradingToGo Forum.
Subscribe To StockTradingToGo.com
reference http://falkininvesting.com/blog/2006/03/22/selling-stock-short-explained/
by Blain on Wednesday 22 March 2006 at 8:35 pm … “100 shares at $450 is $4,500 (100 x $450)” .. I think this is bad math. 10 shares at 450$ is 4,500. 100 shares at 450$ is 45,000$
The rest of the math in the article is inaccurate based on this first error.
Scott, thanks for reporting this! Math corrected, have a great weekend man.
[...] bounce a few times because it will. Don’t mess with the uncertainty…don’t even short it. If you have no fear, then by all means keep it. While it was already a pretty speculative play, [...]
[...] looking through my daily charts I found a perfect example of shorting a stock on lower lows. For the example I am using Holly Corporation (HOC) as it’s chart just today [...]
Hello,
You have some very well written articles on trading. I was wondering if you could explain in further detail when shorting a stock, how the stop limit and stop market works! Before I start shorting, I would like to completely understand how this works and how to protect my profits!!!
Thanks,
Wayne S.
[...] Short selling is the act of selling shares of stock you do not own to a broker, then buying back (covering) the shares hopefully at a lower price and keeping the difference which is your profit. To obtain the best price possible price for your shares you need to utilize more advanced order placements then just a standard market order. This article will explain those orders. [...]
[...] Inverse Exchange Traded Funds (ETFS) are a great way for investors to go short on different sectors or indices without having to actually sell stock short. [...]
When you sell a stock short and Ameritrade for example gives you $4500, where does that money go? Do you earn interest? Do you control whether it goes into a money market or cash, etc? Are you at risk for the money Ameritrade paid you if Ameritrade goes bankrupt? i.e. is the money from shorts also covered by SIPC, and is this investment money not mingled with Ameritrade’s money?
When you short the stock, cash is received and sits in your account. You do not receive interest on the cash. When the short is covered, cash decreases and the shares are returned. The proceeds received on the short are protected via the SPIC. Hope this helps