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Thursday, August 13, 2009

Short Selling of Stock Exchange

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Traditionally the premise of investing is that you buy an asset and hold it until it rises enough to make a sizable profit, it doesn't get much easier than that. What about the times you come across a stock that you wouldn't invest a penny in, you know that stock is doomed, a sure loser. If you knew that the stock was going to decline wouldn't be nice to be able to profit from its decline. Well you can profit from the decline of a stock and although it sounds easy, there are substantial risks and pitfalls that you need to watch out for.

The mechanics of a short sale are somewhat complicated and the investor's risks are high so it is important that you understand the transaction before getting into it.

What does it mean to sell short?

If you sell a stock you don't own, you are selling short. A short seller sells a stock that he believes will fall in value. A short seller does not own the stock before he sells it. Instead, he borrows it from someone who already owns it. Later, the short seller buys back the stock he shorted and returns the stock to close out the loan. If the stock has fallen in price since he sold short, he can buy the stock back for less than he received for selling it. The difference is his profit. Short selling allows investors to profit from falling stock prices. "Buy low, sell high" is the goal of both short selling and purchasing shares ("going long").

A short sale reverses the order of a typical stock purchase: the stock is sold first and bought later. For example, in March 2002, Andy thinks HLL is overvalued. He sells short 100 shares of HLL at $ 5 per share. The stock market crashes in April and HLL's share price falls to $ 4.5 share. Andy buys back 100 shares of HLL and closes out the short sale. Andy gains the difference between the sales proceeds and the purchase costs and pockets $ 88 from the short sale, excluding transaction costs.

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