SIE Ready⚡ Trading & Settlement · Lesson 2 of 6 · 6 min
Going Long, Selling Short and Who Is on the Other Side
🔄 Selling a stock you do not own sounds impossible. It is legal, common and carries a risk with no ceiling.
💡 Key idea
Long risk is capped at the cost; short risk is unlimited. Agent earns a commission, principal earns a markup or markdown, and 5% is a guideline, not a ceiling.
🧠 Why it matters
LONG means you own the security and profit if it rises; the most you can lose is what you paid. SHORT means you sold borrowed shares and must buy them back later; you profit if the price falls. Because a price can rise without limit, a short seller's potential loss is unlimited. Short sales happen in margin accounts. Regulation SHO's LOCATE rule requires the broker-dealer to have reasonable grounds to believe the shares can be borrowed before the short sale. Capacity: as AGENT (broker) the firm matches buyer and seller and charges a COMMISSION; as PRINCIPAL (dealer) it trades from its own inventory and charges a MARKUP or MARKDOWN. FINRA Rule 2121 requires fair prices; its '5% Policy' is a guide, not a rule.
📈 In the real world
🧾 Malik, a fictional customer, shorts 100 shares at $40. The firm first locates shares it can borrow. The stock rises to $65, and Malik's loss on paper is $2,500 with no upper limit. Separately, his bond purchase is filled from the firm's own inventory, so his confirmation shows the firm acted as principal.
📌 Takeaways
- Short sellers borrow, sell, then buy back to return the shares
- Reg SHO: locate shares that can be borrowed before shorting
- Agent = commission; principal = markup or markdown; 5% Policy is a guide
📖 Terms in this lesson
Short sale: Selling borrowed stock in hopes of buying it back cheaper later; potential loss is unlimited.
Locate requirement: Under Regulation SHO, a firm must have reasonable grounds to believe stock can be borrowed before accepting a short sale.
Markup / markdown: A dealer's charge above (markup) or below (markdown) the prevailing market price; FINRA's 5% policy is a guideline for fairness, not a fixed limit.
✅ Test yourself
What is the maximum potential loss on a short sale of stock?
- The margin deposit
- The sale proceeds
- Unlimited in theory
- Half the sale proceeds
Answer: C · Unlimited in theory
A short seller must buy the shares back, and a stock's price has no upper limit, so the loss is unlimited. The proceeds or margin deposit are not caps.
A firm sells a customer stock from its own inventory. In what capacity is it acting?
- Agent, earning a commission
- Principal, earning a markup
- Broker, earning a fee
- Agent, earning a markdown
Answer: B · Principal, earning a markup
Selling from its own inventory makes the firm a dealer (principal), and its compensation is a markup. Agents (brokers) arrange trades for others and charge commissions.
Which statement about FINRA's 5% Policy is accurate?
- It applies only to bonds
- It bans all markups over 3%
- It caps every markup at 5%
- It is a guide, not a rule
Answer: D · It is a guide, not a rule
Rule 2121's supplementary material says the 5% Policy is a guide. A markup above 5% can be fair, and one below 5% can be unfair, depending on factors like the security and the amount of money.
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