Selling short

Also known as short selling, is the practice of selling a security that the investor does not own.

This curious practice is intended to allow the astutue investor to profit on the depreciation in price of a companys stock price.

It works as follows :

Consider a programmer who suspects that IBM's shares are wildly over valued. Note that she does not own any IBM stock at all.

She shorts IBM shares, or sells them at the current market price, say $100 a share. She receives $100 in cash for every share she sold. She can do whatever she likes with this cash, since it is her money from this point on.

Meanwhile, on the other side of the transaction, someone has bought the IBM shares that she sold.

To deliver these securities to the purchaser, her brokerage firm will borrow IBM stock from the dormant holdings of an institutional investor.

Institutional investors are defined as the large pension and mutual funds, who typically will buy and hold shares for long periods of time. By participating in short selling this class of investor is able to earn additional fees from their shares.

Note that the programmer has effectively borrowed something - in this case, IBM stock - and sold it. For this privledge she must, of course, compensate the real owner.

She pays interest to the institutional investor in the form of a small fee, which is known as the broker call rate.

Someday, however, she must close out the position and return what she has borrowed. To do this, she must acquire IBM shares in the open market.

To complete this example, assume that IBM sharply drops to $30 a share. The lucky programmer purchases it at this price, and repays her loan from the institional investor; this is called closing out a short position

The difference, $100 - $30 = $70 is her gross profit per share sold.

She must also, of course, include any interest and brokerage fees that she paid to determine her net profit.

Short selling is clearly a very risky trading strategy. If IBM had gone to $200 a share, the programmer would have lost $200 - $100 = $100 A SHARE.

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