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What Is Short Selling and its margin account?

Short selling
Successful short seller in a bear market

Short selling and it’s risks

Investors who make short sales borrow stock today and then sell it via the use of a margin account. Days or weeks later, the investor will then buy the stock to return the position to its lender. In between the borrowing time and buying the shares, the stock price will fluctuate. When short selling, the investor is hoping that the stock will go down in price. If the security does indeed go down , the short seller will be able to purchase the stock for less than they sold it. The investor then pockets the difference.

People often think you must own a stock in order to sell it but this is not the case. You can sell a stock by borrowing it now and buying it back later. This is called “selling short” or short sell.

However, short selling is risky. Long purchases ( the regular way), only present the risk of the stock going bankrupt. In this situation you lose 100% of your investment.

What happens in short selling is that a bankrupt stock is the best thing that can happen, but the worst that can happen is stock price rise. If that happens, there is no limit to the amount of money you could lose because the stock can rise to multiple times its value.

First and foremost, you must have a margin account. This account uses your own eligible securities as collateral.

Stock can be classified as easy-to-borrow (ETB) or hard-to-borrow (HTB). Hard-to-borrow implies a limited supply of a stock available for short sales. In this case, you will have to pay a daily stock borrowing fee which charges based on a stock’s price and availability.

When the original owner decides to sell their shares, your short will continue to be borrowed if ETB. If HTB, there might be a fee to continue to borrow the shares. There is always the possibility that shares will be unavailable implying the short will be closed out the current market price.

If a stock pays a dividend while it is borrowed, the original lender will typically get a substitute dividend payment, and the borrower will have the same amount debited or withdrawn from their account.

Here is what a short-sell looks like at Schwab:

You can see that the quantity and market value numbers are listed with parenthesis around them to indicate that they are negative numbers.

In this example, the 4,000 shares of short VDE are a debt to the client currently valued at $205,840. If they choose to repurchase now, this is the amount they will pay to end the short sale.

The capital gains treatment of short selling is also not intuitive. Most people think that the tax treatment should begin with the short sell itself, but this is not the case. The holding period begins when you purchase the security to close the short sell and the holding period is one day. This means that the proceeds of a short sell are always a short-term capital gain or loss. There are more complex rules for shorting your own position, meaning a position that you already own.

We do not recommend short selling.

On average, you will lose 0.03% every day, 0.17% per week, 0.77% per month, and 8.81% per year on just price movements. But the stock market is rarely average. Individual stocks are much more volatile and that volatility will catch you unawares. Even if you have had a couple of wins, in the long run short selling is a losers game. When you lose, you can lose big with no limit to the amount of money that you can lose.

Even if you are sure that a given stock will go down, all the reasons you have are public knowledge. You may think that everyone else is crazy, but their craziness is the fair market value for the stock. You could get burned trying to be rational.

Photo by Blake Weyland on Unsplash

Follow me on Twitter or LinkedIn. Check out my website or some of my other work here.

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