You can make money short selling a stock if its price goes down – but if its price goes up, your losses could be unlimited. [This short article outlines the theory behind short selling and what you need to know before doing so.] Words: 333
When you short sell a stock, you borrow shares from your investment firm because you think that the price of the stock is going to fall. You sell the borrowed shares at the current price and if the price drops, you make money by buying the shares back at the lower price and then returning them to your investment firm. If the price rises, you’ll lose money if you have to buy back the shares at the higher price.
The theory behind short selling
- Borrow shares – usually from your investment firm
- Sell them – at the current price
- Buy them back – at a lower price and make a profit
- Return the borrowed shares – to your investment firm (called covering)
If the share price goes up instead of down
You’ll lose money if you have to buy back the shares at the higher price, and then return them to the investment firm. Theoretically, there is no limit to how high the price of a stock could go – losses could be catastrophic. This is the greatest risk of short selling.
3 things to know about short selling
- Short account – You must have a short account to engage in short selling. A short account is a type of margin account.
- Delivery of shares – Your investment firm can require you deliver the shares to them at any time. You’ll have to buy back the shares at the current market price and return them to the firm. If the share price has gone up, you’ll lose money.
- Dividends – Because you don’t actually own the shares, you have to pay your investment firm any dividends that are declared during the course of the loan.
The comments above are edited ([ ]) and abridged (…) excerpts from the original article by Investor Education Fund (www.getsmarteraboutmoney.ca)
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