Short Selling and Its Restrictions

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short selling the marketShort selling has been a popular trading strategy for years, dating back to the early 1900s. There were no restrictions on short selling at one point. Regardless of the status of the stock that is selling, traders were able to short sell. Recently, in order to regulate the market and keep this practice from affecting the market in a negative manner, restrictions are in place.

Overall, short selling is a perfectly legitimate trading strategy. It can yield large profits if you know what you are getting into. While many may have heard of this trading tactic, most do not actually understand exactly what it means to short sell or how to use it to their advantage. By having an understanding as to what exactly short selling is and how it has helped many people make money, you can decide whether or not it is a good opportunity for you.

Short Selling and Its Restrictions

The following is everything you need to know about how to short sell and its restrictions. You can use this to determine whether or not it is a good opportunity for you.

What is Short Selling?

Short selling is the process of borrowing and selling a stock, and then purchasing the position back in order to make a profit. The basic premise of this pratice:

  • sell a position right before the moment a price of stock drops;
  • After the price drops, the trader can purchase the exact number of shares back at a much lower price;
  • the trader borrows the stock instead of purchasing the stock for themselves, they are able to turn a profit after purchasing the stock back at a lower price.

For example, suppose a trader and their broker borrow a hundred shares of stock from a company. They are able to sell the stock at $50 a share. A week later, the price of the stock falls to $40, the trader buys back a hundred shares of the stock. This means the short seller makes a profit of $1,000. This happens if they sell the stock at $5,000 and are able to purchase the stock back at a price of $4,000.

Related: How to Invest Outside of Your 401k

What are Short Selling Restrictions?

A  restriction is a regulation over the act of short selling by the Securities and Exchange Commission. It ensures that this trading tactic does not have a negative effect on the market as a whole. The most widely discussed  restriction is what is known as the uptick rule. The uptick rule was first established in 1934, following the great depression. Initially, the uptick rule placed limitations on the ability of traders to short sell on stocks.

Short sellers could only sell a stock if there were an increase in value from the previous trade. If the last transaction took place at a price of $5.17 per share, short selling could only take place if the stock is sold at $5.18 or higher. A new version of the uptick rule was adopted again in 2010. It restricts this trading practice if the stock drops more than 10% in one day.

Why are Restrictions Necessary?

As mentioned, the first implementation of restrictions took place in 1934, which was right after the great depression. In many ways, the scapegoat for the Great Depression was short selling and the logic was that it had a negative impact on the stock market as a whole. The removal of restrictions begin in 2007 since no clear indications that short selling affects the market in negative ways. The stock market crash of 2008 leads to the restrictions coming back in 2009 under much of the same logic of the 1930s.

The reason for restrictions are to keep short sellers from driving the market down too far. The idea behind short selling is to purchase the position of the stock back at the lowest possible price after selling at a high price. When too much short selling takes place at once, it can cause the stock market to plummet.

The most recent revisions to the uptick rule keep short selling from happening in the event a stock drops 10% or greater in one day. Not allowing traders to short sell in these extreme market conditions helps to ensure that a stock does not crash.

How to Short Sell Successfully

Even though it is considered a fair trading tactic, it can be challenging to short sell successfully. This is why expert traders and brokers utilize this trading technique. This is because if a trader sells stock and is unable to buy back at a less expensive price, they will end up losing a significant amount of money.

In order to short sell successfully:

  • obtain information of all restrictions to ensure all laws are followed. You can click here for more information about short selling restrictions;
  • have a full understanding of the stock that is selling,
  • be well informed of the activity that is expected to take place with the stock.

Conclusion

In order to borrow a stock for short selling, it may require a good broker who is successful. Even then it is important to be fully aware of the risks. If you have any experience with the practice of short selling, leave a comment with any advice you may have in the section below.

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LaTia Longuemire

AUTHOR LaTia Longuemire

My name is LaTia Longuemire. I enjoy writing, singing, and cooking in my spare time. My passion is helping others. At this stage in my lifetime, I'm primarily focused on my children. They are everything that keeps my world spinning.

2 Comments

  1. I would like to add a couple of things to this article.

    First off, one doesn’t borrow stock from a company, one has to borrow a stock out of an investor’s portfolio and sell the stock, collecting the selling price (less selling commission) and promising to replace the borrowed stock at a later time.

    While you are short a stock that pays dividends you become responsible for paying the dividend to the party from which you borrowed the stock. Also, the broker will charge you a borrowing fee of between 2% and 10% annually until you replace the stock by purchasing the same amount of shares (more if the stock split while you were short) paying purchasing commission and returning the shares to the account from which you borrowed it.

    There are many other points to consider but this is a good starting point. I would recommend Investopedia.com for those who would like to learn more about short selling or investing in general.

    • Yup and yup. Good adds, Cooper.


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