First, let's describe what short selling means once you buy shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most typically used. They function as an intermediary between the investor and the seller and usually charge a fee for their services.
When using a broker, you must set up an account. The account that is set up is either a cash account or a margin account. A cash account needs that you pay for your stock when you make the purchase, however with a margin account the broker lends you some of the funds at the time of purchase and the security acts as collateral.
When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. On the other hand, when an investor is short, he or she is anticipating a decrease in share price.
Short selling is the selling of a stock that the seller does not own. More specifically, a short sale is the sale of a security that is not owned by the seller, but that's promised to be delivered. This may sound confusing; however it is truly an easy concept.
Still with us? Here's the explanation: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you have to "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price falls, you may buy back the stock at the lower price and make a profit on the difference. If the price of the stock goes up, you need to buy it back at the higher price, and you lose money.
Most of the time, you may hold a short for as long as you wish, although interest is charged on margin accounts, thus keeping a short sale open for an extended time can cost more, However, you can be forced to cover if the lender needs the stock you borrowed back. Brokerages cannot sell what they do not have, therefore you will have to either come up with new shares to borrow, or you will have to cover. This is referred to as being called away. It does not happen often, however it is possible if many investors are short selling a specific security.
Because you do not own the stock you are short selling (you borrowed and then sold it), you have to pay the lender of the stock any dividends or rights declared throughout the course of the loan. If the stock splits throughout the course of your short, you will owe twice the quantity of shares at half the price.
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