Can anyone explains how the principles of short selling works? and how do brokers make money on that?Thanks?

Answer 1

Short selling is a bet that a firm's stock price will drop. Your broker loans you shares that the brokerage owns and you sell the loaned shares (sometimes back to the brokerage) at the current price. You pocket the proceeds of sale, but are on the hook to pay off the loaned shares.

If the stock price drops, the loan amount drops, since the shares are worth less than at origination. If the stock price rises, the broker will generally call for you to cover the added value outstanding. When you cash out the short position, you buy the shares at the reduced price and repay the loan (in stock) at the current stock price, plus interest and fees (to the broker) where applicable.

Now, the fun part...why would a bank do this (loan shares) instead of liquidating a long position for a gain? First, different investors have different opinions about a firm's future. Also important, short-selling is limited to high-net-worth individuals, partly to cover the added risk, and a bank will do this (loan shares) for HNW customers to gain or keep their other business (long positions, banking, insurance, etc.).

Answer 2

In short selling, you sell shares you don't own.

How's this possible? Your broker will loan you the shares. Then you sell it. Now, you owe your broker the shares you borrowed. You must return these shares to him.

You'll wait until the share price drops and buy those shares, then you return the shares to your broker.

Because you sold at high and returned at low, the difference is your profit.

Your broker benefits because he will charge a fee to sell and buy (twice) and there is an interest/fee involved when you borrow shares so you can sell.

Be careful with this... Normal trade (called "long") gives you a protection that you could NEVER lose more than you put in. In short trade, if the share price goes UP, instead of down, you have UNLIMITED liability. You could lose twice or more of your investment. Usually, the brokerage will ask you to pay in to your account so that their loss is limited, but the same thing can't be said from your prospective.

Answer 3

This is where you believe a stock to be overpriced. So you borrow the stock from another entity by putting up at least 50% cash as collateral and then selling the borrowed stock. When you have to pay back the borrowee for the stock you borrowed the idea would be to buy it from market at a cheaper price than you sold it for.

Oh yeah one other pitfall here is that you won't have the capital gains rate tax shelter. You will be paying full income tax on what you make since you did not hold the stock for longer than a year.