Short sale

The sale of shares of a security that the seller does not own. Such sales are made in anticipation of a decline in the price of the security to enable the seller to cover the sale with a purchase at a later date, at a lower price, and thus at a profit.

How does this work? Your broker finds someone that has the security, borrows it from them with the promise that you are going to return it at some future date, and then sells it on your behalf. If the stock price goes down you can buy the stock back at a lower price than you received upon the sale and consequently you profit. If on the other hand the stock price goes up then you will have to buy it back at a higher price and you lose.

At the point that your short transaction executes you now have what’s known as a “short position” (as opposed to when you actually own a stock and it’s called a “long position”). You also become liable for not only returning the stock but also for paying any dividends to the lender that they would otherwise be entitled to since, thanks to you, they no longer really have the stock – though they don’t even know that since the stock continues to show up on their broker statement like nothing has happened. The lender doesn’t need to know what’s going on behind the scenes because you better believe that your broker is going to make sure that you live up to your commitment.

Once you have the short position a few things happen. First, the broker takes the dividends out of your account whenever they are due in order to pay the lender. Second, since you have to return the stock at some point your broker wants to make sure that you are going to have the money to buy the stock back. So, on a regular basis (perhaps once a week) they mark the position to market – which means that they take cash out of your account to cover any increase in the price of the stock since the last mark to market that you will have to pay in order to replace the stock or they put cash back in to reflect any decrease in the price of the stock.

Securities and Exchange Commission rules allow investors to sell short only when a stock price is moving upward (the uptick rule). This prevents "pool operators" from driving down a stock price through heavy short-selling, then buying the shares for a large profit.