CHAPTER 1

Introduction to Short-Selling

Reduced to its mechanics, short-selling is simply the act of identifying a change of trend in a stock from up to down and then seeking to profit from that change of trend as one rides the stock to the downside. To do this, the investor or trader sells the stock in question while not actually owning it, e.g., being “short” the stock, and pockets the proceeds of the sale with the idea of buying the stock back later at a lower price as the downtrend takes hold and extends to the downside. To go short, the seller must first borrow the stock from her broker and may have to pay a very small fee to do so. If and when the stock drops in price, the seller then repurchases the shares, “covering” her short position for less than she sold them, returning the borrowed securities and pocketing the difference. This is, of course, not a risk-free proposition, as the short-seller may also end up owing the difference if the stock rises in price and the cost of buying back those shares exceeds the proceeds they pocketed at the time of the initial short-sale. Because stocks can theoretically rise to infinity, while their decline is finite given that a stock price cannot go below zero, or 100 percent of its current value, then the potential losses a short-seller faces are unlimited. Of course, this assumes that a short-seller is operating without a stop-loss that provides a clear point at which the short-sale would be covered and the trade closed out at a loss, ...

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