Rules For Short Selling
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Short selling can be defined as a trade practice where a security, commodity or a contract is sold by an investor who is not the owner of the stock. The prime objective of a short sale is to capitalize on a security whose value might decrease in near future. Here, the broker lends the seller some shares that can be sold at a higher price. Once the price of these securities decline, the seller can buy back the shares at a lower price and replace them to the broker. The difference in the sale and purchase price is pocketed by the seller.
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Short sales are highly profitable since traders can money through these even during the lean market situations. Short traders have an edge since prices tend to decline faster in a stock market. However, there are certain rules that one must follow in a short sale.
The foremost rule is that not all shares are applicable for a short sale. This is dependent on the jurisdiction of the broker. However, larger the broker better are the chances of obtaining a stock for short sale. Most of the times, brokers maintain a list of stocks that are hard to borrow and are not available for short selling.
Next important short sale rule is the upstick rule. As per the SEC rule, short sale should only be made on an upstick or a zero-plus tick. One cannot sell them on a downtick. Upstick means trade at a higher price than the previous trade. Downstick means trade at a lower price than previous trade. Zero-plus tick means trade at a similar price to previous trade. This rule is also called the “plus tick rule” or the “tick-test rule”.
Another important rule is that shore sale can only be made in rising markets. The seller must have a margin account during the trade.
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