What is a Short Sale of Stocks?
Short Sale of stocks refers to the transaction in which the seller first borrows the security from the broker and then sells it in the open market and thereafter, buys the security back at an appropriate time to pay it back to the broker. In this, the Buyer of the security has to buy back the Stock from the Broker in order to cover his open position. They are basically called as a Margin Transactions in which the settlement of the Trade happens on the Net margins and not actual delivery of the Stock. There are certain guidelines which need to be followed for the Short Selling to be done by the investors in respect of minimum margins to be maintained with the Brokers
- In real estate, it refers to a transaction wherein the property which is mortgaged with the lenders is sold in the market at a value which is less than the debt owed on it. In this case, if the lenders agree to the transactions, the Net difference between the Sale price and the Debt owned against it is referred to as a Short Sale.
- In Short Selling of stocks there are more stringent rules laid down by the SEC due to the high risk and exposure in the same. In Short Selling, settlement happens weekly or it depends upon the agreed terms.
Examples of How Short Sales Stocks Process Works?
Below are some examples of how short sale of stocks works?
Short Sale Stocks Example #1
Let us assume that an investor Short Sells security on the Exchange by borrowing the same from a Broker ie 1000 shares @ $20 = $20,000. The stock price moves down by $2. In this case, the Investor needs to buy back the Security from the Broker @ $18 in order to cover the position and hence there is a profit of $2,000 on this transaction which is been paid by the Broker to the Investor.
Below mentioned are some of the Journal Entries that need to be passed after Short Selling.
The Stock moves down by $2 to $18.
At the time of Settlement
In the Above Examples, the trader makes $2,000 just by putting a trade on the Stock Exchange via a Broker without possessing that Stock in his Demat Account. For this, the Broker charges a certain amount of Fee to the Trader to execute the trade which is known as Transaction fee which gets deducted from the initial margin the trader has given to the Broker as a Security.
Thus the Trade has made a profit just by selling the Security at a higher rate and then buying it back from the market when the rate dropped below the Sell rate which has resulted in a net profit of $2,000 to the Trader and Fee income to the Broker for availing this facility.
Short Sale Example #2
Let us assume that in case of a Real Estate Transaction, ABC Limited owns a property whose market value is $5,00,000 and the Debt owed against the same is $ 4,50,000. IF the Company wishes to sell the property at $ 3,50,000, it will have to take NOC from all the lenders in order to go ahead with the transactions since their Financial interest is been affected due to the lower realization in the same. If the lender agrees on the Sale, it would be referred to as the Short Sale of the Deal by $ 1,00,000
Advantages of Short Sale of Stocks
Below are some of the Advantages.
- Liquidity: The Investor who does not have money to trade in the Financial markets can trade by giving a small margin and building a bigger position.
- High Rewards: This comes with a high Risk and Return relationship wherein the Short Seller makes super profits in case of wild fluctuations in the Stock moving in favor of the investor.
- Ownership not required: The Trader does not require to hold the Stock in order to trade
- Monitor and Control of investment: The Trader can secure his position by applying a various limit, or Market price orders in order to cover his position so that he is secured by any kind of loss ahead.
Following are disadvantages of a short sale of stocks.
- High Risk: Since it is in the F&O market, the Risk of losing a high amount of funds is more.
- Subject to Lenders Approval: Short Sale in a real estate transaction comes with a NOC from the existing lenders to settle at a low value of the property.
- High Margins: The Traders needs to keep a high amount of margins with the Broker thereby securing his Financial interest in the event of.
- Regulations: There are various regulations set by the SEC and the Stock Exchanges in entering into a Short Sale transaction in the Financial market.
- Lengthy process: It is a lengthy process since the Short sale needs to be approved by the Lenders since the property will be sold at a lesser valuation as compared to the normal route.
- Opportunity Cost: Short Sale comes out with an opportunity cost wherein the Amount recovered shortly is a cost to the Transaction and can be considered as an Expense in the same.
This has been a guide to short sale of stocks and its meaning. Here we discuss examples of a short sale of stocks along with journal entries, advantages, and disadvantages. You can learn more about Financing from the following articles –