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Selling Short and Buy to Cover Orders (Continued)
A short sell order means you tell your broker to sell shares of stock that you don't own. If the stock falls, you can close the transaction with a buy-to-close order, replacing the borrowed stock and pocketing the difference.
To take advantage of the situation, you enter a short sell order for 1,000 shares, borrowing the $10,000 worth of ABC shares (1,000 shares x $10 each) from your broker, selling them on the open market, and pocketing the cash. You hope that the price of ABC common stock will fall, you'll be able to purchase the shares at a lower price and return them to your broker, pocketing the difference. If, for example, ABC fell to $7 per share, you could repurchase the 1,000 shares for $7K by placing a buy to cover order, return them to your broker and pocket the $3K profit. (The buy to cover order is not the same as a regular market order; it effectively returns the borrowed shares to your broker and must be used to close your short position
There are a few rules regarding short selling that are important:
- In order to sell short, you must have margin privileges on your brokerage account.
- You cannot short a stock as it is falling in price. For exchange-traded securities, short sales can only be placed if the most recent trade is higher than the previous one (known as an “up-tick”) or equal to the previous trade (known as a “zero-tick”). Over-the-counter securities can only be shorted on up-ticks.
- You must maintain enough purchasing power in your account to place a buy to cover order on your short sale. If the stock price increases on your shorted security, you may face a margin call to ensure you have to capital necessary to repurchase the stock and return it to your broker.