Technically, you sell stocks short as you borrow shares from a broker to sell and then buy to cover. This type of trade contrasts the conventional stock purchase in that you make money when the price falls. To short stocks, you must meet your broker's margin requirements. Short sellers need to recognize the more compelling risks of shorting relative to a conventional stock purchase.
When you short stocks, you sell shares on loan from the broker. This transaction creates risk for the broker in that you incur a liability until you buy to cover the loan. For that reason, brokers require that you meet certain margin requirements. "Margin" means that you have the ability to buy with funds in the account, as well as with credit. On a 50 percent margin account, for instance, you have the ability to trade with up to $60,000 if you have $30,000 deposited. When you short, the bank requires that you margin to cover losses if the stock appreciates.
The starting point for a short sale is simply to sell shares of stock you don't own. You enter a sale of the number of shares you desire to short using your broker's trading platform. When you don't own the shares on a sales transaction, you borrow them from your broker or another firm. The goal of a short-sale transaction is to get in at a relatively high stock price. If a company trades at $40 and you think it is overpriced, you might short the stock by entering a sales transaction with an expectation of a price drop.
Buy to Cover
The complementary transaction on a short sale is a "buy to cover" transaction. Buy to cover means that you acquire shares to cover the borrowed shares that you sold, and you profit from the earnings. On your $40 short sale, if you buy to cover at $25, you have a profit of $15 per share. When you buy to cover, the transaction is considered settled or closed, and you no longer have a liability to the lending firm. Essentially, you conduct a trade in reverse. You sell first at a high price, and then buy to replace the borrowed shares at a low price. It is similar to borrowing a new product to sell to someone at $40, buying a replacement when the price declines to $25 to repay the loan, and pocketing the $15 difference.
Not all short sales work out favorably. Just as a buyer loses when a stock drops, short sellers lose money when a stock gains. In fact, short sales incur greater risks because the price can rise infinitely. In contrast, a stock can only fall to zero. Along with significant losses, a broker may require you to add funds as the stock price rises and you lose margin. A short seller has to pay dividends to the broker or lender of the shorted shares if the trade is still open on the company's dividend execution date.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.