How to Sell a Stock Short Monday January 21, 11:29 am ET

The most basic way to trade the short side of the market is to sell stocks short. While selling stocks short is in some ways just the opposite of buying stocks, there are some important differences. In order to sell a stock short, there must be shares of the stock available to your broker for you to borrow. When traders sell stock short, they essentially borrow stock from their broker and sell the stock in the market. Because the trader has sold something he or she does not own, eventually the trader will need to buy back the stock he or she sold.

The short seller believes that when the time comes to buy back the stock, that stock will be at a much lower price than it was originally sold for. This enables the short seller to buy back the stock at a cheaper price, return it to his or her broker, and pocket the difference as a profit.

For example, a trader wants to short stock Research in Motion (NasdaqGS:RIMM - News).
The trader borrows 100 shares of the stock from his broker and then sells it for the going price of $120 a share. RIMM does move lower as the trader expected, say to $90 a share. The trader would then buy the same amount of RIMM that he or she originally borrowed--100 shares--on the open market, and then returns the stock to his or her broker.

The trader sold 100 shares for $120, gaining $12,000. The trader then bought back or "covered the short" by buying 100 shares at $90 ($9,000). The difference between the amount earned by selling the shares and the amount it cost the trader to buy the shares back after they moved lower is the profit of the short trade, in this case $3,000

If the stock does not move lower and, instead, moves higher, then the trader selling the stock short will still have to "cover" or buy back the stock he or she borrowed. But the trader will be doing so at a loss.

For example, if RIMM advanced by 10 points instead of falling by 30 in the example above, the trader would have had to buy or cover his or her short position at $130. Having made $12,000 from the initial sale and then spent $13,000 buying the stock back when ABC went the wrong way, the trader would realize a loss of $1,000.

In order to sell a stock short, the trader typically must have a margin account set up with his or her broker. Because of the risks involved in selling an asset that the trader does not own--and the possibility that the stock will be at a significantly higher price when the time comes to cover or buy the stock back--a margin account is required to ensure that the trader has sufficient capital in order to buyback a position went against him or her.

The margin amount, which is set by the broker, serves as a sort of collateral in the event that the trade goes badly. This collateral may be in the form of cash or securities such as stocks. If the losses from the short sale trade grow larger than the amount held in margin, then the trader will get a "margin call" from his or her broker, requiring the trader to either liquidate the position immediately or provide additional capital. Additionally, the trader will have to pay interest on the margin--at least, to the degree it is used. The margin is essentially money borrowed from the broker, the interest paid in this sense is no different that the interest a trader might pay on a loan from a bank.

For many years, selling stock short was complicated by what was called the "uptick rule". This rule meant that traders could only sell a stock short if and when it's last trade was higher than the previous trade price (creating an "uptick"). This rule had been in force for decades, but was recently eliminated by the Securities and Exchange Commission effective July 2007. This has made it much easier for traders to sell stocks short.

Another phenomenon that traders looking to sell stocks short should be aware of is called the "short squeeze." A "short squeeze" occurs when a large number of traders who are short a stock begin covering or buying back the stock at the same time. This rush to cover can have a dramatically bullish impact on a stock, particularly one that has been heavily sold short. Being caught with a short position in a stock when a "short squeeze" occurs is one of the risks in selling stocks short that trader need to be aware of.