Canadian Securities Course (CSC) Level 1 Practice Exam

How does shorting on margin work?

1. Client borrows money from broker

2. Client buys shares with borrowed funds

3. Client sells borrowed stock in the market

4. Client sells own shares to cover losses

The correct answer is: Client sells borrowed stock in the market

Shorting on margin involves a client selling borrowed stock in the market. When an investor shorts a stock on margin, they borrow shares from their broker with the expectation that the stock price will decrease. The investor then sells these borrowed shares in the market at the current price. If the stock price does indeed decline as anticipated, the investor can buy back the shares at a lower price to return them to the broker, resulting in a profit. If the stock price increases instead, the investor may have to buy back the shares at a higher price to cover their position, incurring a loss. This process of selling borrowed shares in the hopes of buying them back at a lower price is what shorting on margin entails.