A trader or investor who sells a stock that he does not own, hoping the price falls later on is selling short. This is a risky form of trading, as the market on the shares could rise on the investor.
The person must buy back or cover the stock, so the investor needs to be careful with watching price movement and direction.
Most broker dealers will permit this practice when it is done in a margin account. The stock trader will put in money above the proceeds of the short sell to cover the brokerage firm, in case the stock rises.
Selling short should only be for experienced investors and day traders.
Options and Short Sales
LONG CALL protects SHORT STOCK
A customer sells 100 shares of XYZ short at $37 and wishes to protect against a sudden increase in the price. A Registered Representative recommends that the customer Buy 1 XYZ DEC 40 call paying a $200 premium. The Call option gives the holder the right to buy the stock at 40, thus limiting the potential loss on the stock to 3 points plus the $200 premium. The stock needs to decline at least to $35 to pay for the option and to reach break-even on the short stock position.
SHORT 100 Shares @ 37
BUY 1 DEC 40 CALL @ 2
The call option protects the short sale until December
The option costs $200 which lowers (more difficult) the break-even needed to $35
Option will expire should the stock decline in the investors favor
Maximum Gain: $3500 (Short sale to decline to “0” minus the premium paid)
Maximum Loss: $500 (Sold short at $37. Option allows for buy at $40 plus the premium paid)
Break-even: $35 (Stock needs to decline 2 points to make up premium paid)
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