With the current real estate crisis in full bloom, the term short sale has taken on a an entirely new meaning compared to the traditional interpretation of the past decades. Today most people would tell you that a short sale is a house being sold for less than the mortgage owed on it
And they’d be right. At least from the context of real estate
But there’s another meaning to the term short sale, and investors in securities have been using it since the advent of the stock markets themselves.
Shorting Stock for Fun and Profit
In that context, a short sale is the selling of a stock you don’t own. In essence, selling a stock you’ve just borrowed from someone else (because the buyer still needs to take delivery of the actual stock they’ve just purchased).
Short sales always take place within a margin account, since the investment firm is at risk if there isn’t sufficient equity to cover the short sale in the event the trader unable to cover the debt. In that case they would sell off existing securities – the equity in the account – to the extent required to purchase the stock that is to be repaid to the original lender.
This is called covering – the purchase and repayment of stock borrowed to deliver on a short sale transaction.
Why would anyone do this?
That’s simple – to make money in the event the price of a stock goes down. The investor is literally betting that the stock will decrease in value.
If you can sell someone a share at $15, and in two months that share is only worth $10, you make money. Because to cover the sale (repay the stock that you borrowed to deliver at $15, which you must do at some point), you’ll need to buy the stock in the open market at prevailing prices, in this case, $10. You’ve just made a $5 per share profit.
The reverse is true, as well
If you’re wrong and the price goes up, you still have to eventually cover the short sale by purchasing the stock in the open market so you can give it back. In this case, what you sold for $15 is now worth $20, which means that’s what you’ll have to pay for it in order to return it to the original owner.
A Strategy for Every Investor, and Every Market
The mechanics of this borrowing process are handled by the investment firm behind the scenes. Only the pricing affects the investor.
Like options trading and day trading, short selling stock is a practice most often used by experienced and risk-tolerant investors who fully understand the dynamics and prospects for the market.
But for them, and for the rest of us, the age-old truth applies: what goes up must come down, and vice versa. And there’s money to be made in either direction.