What Is a Short Sale?

The following is a transcript of the video above.

In what type of account can short sales be executed?

The answer is margin accounts because the short seller is borrowing stock. The short seller is not borrowing cash. Your traditional margin idea is that you borrow some money, buy some stocks, that’s one way to borrow, but what are we borrowing? We’re borrowing stock to sell it and then what do we have to do to close the position? We need to buy or sell? We need to buy stocks and then return them to the lender.

Let’s try an example

Leg One: If Broker Dealer A lends 100 shares of ABC stock to Sam “short seller” and Sam sell 100 borrowed shares to Bob “buyer” at $20 per share, what happens? Sam earns or receives $2,000 for the sale. Bob owns the stock. Is Bob in the picture anymore? No, he’s done.

Leg Two: Sam “short seller” wants to close the position. What does Sam have to do? Sam has to return 100 shares of ABC to Broker Dealer A. So, Sam buys 100 shares of ABC in the market and then returns them to Broker Dealer A. What is the price that Sam pays for the shares? For $25 per share, Sam takes ownership. Is Sam happy? No. He sold at $20 and bought at $25, with a loss of $5 per share. If on the other hand, he bought the new shares at $18 per share, he would be happier. This is called covering, with a gain of $2 a share.

The last piece of the puzzle that you might see is that when Sam gets the $2,000 – let’s say 10,000 shares, just for the illustration here. When Sam receives $200,000, does he need to meet Reg T? Yes or no? Yes. How much cash must he deposit? 50 percent. So his account now has $200,000 in proceeds, plus $100,000 in Reg T equals $300,000 total. I bumped this up, so we would not run into the FINRA rules around $2,000. Remember, this is Leg One, where I borrow the stock, sell it, get the cash, and then I’m sitting on a pile of cash. And then I use that pile of cash to buy the stock back at the price.