Short Selling

I have found myself receiving a number of questions involving selling a stock short but I have been hesitant to answer them, and I'll explain why later in the article. If you do intend on using this investing technique, I strongly urge you to read the entire article.

When we hear stories of people making money in stocks, we have these pictures in our heads of them buying the stock dirt cheap and selling it for much more than they bought it for. But this isn't the only way. Another way people can make money with stocks is to buy them when they're high and sell them when they're low and it's called short selling. I know, this all sounds crazy but it is actually possible.

Selling a stock short basically means that you buy the stock when it's high with the intention of selling it when it's lower. The way this works is that the investor makes a "short" trade with his broker. This trade tells the broker to lend the investor a certain amount of shares at the current price. Rather than keeping these shares held in an account, they're sold immediately and the investor is given the value of how much they are worth. So it sounds like free money, right? Not quite. The investor still has the liability to return these shares to the broker. When the investor thinks that the stock is low enough, he puts in a "short cover" order with his broker that allows him to buy back the shares. He or she then returns the shares to the broker and keeps the difference between the price he originally sold it for and what he bought it back for. I know I know, it's confusing. So here's an example:

John decides that he thinks XYZ stock is ready for a fall so he goes to
his broker and shorts 20 shares at $50/share. That means he has
$1000 in his account. The stock drops down to $40/share and he
decides he wants to buy them back to return them to the broker so he
buys 20 shares at $40/share for $800. He then returns them to the
broker and keeps the $200 difference.

It sounds pretty good at first but you should be fully aware of the risks before you decide to do so. The largest risk that you have is for the stock goes up. If John's stock would have went up to $60/share, he would have had to cough up $200 out of his own pocket just to return the shares.

Anytime there's money to be made, there's also money to be lost. And with short selling, you can actually lose more money than you originally invested. For example, if John kept holding XYZ stock and it skyrocketed to $150/share, he would have to buy the shares back and that would cost him $3,000. That means he would have lost $2,000 even though his original investment was only $1,000. However, John can balance out his risk by using buy and sell orders with his trades. By doing this, he can reduce a lot of the risk involved with short selling.

Short selling is mostly for the short-term investor and I encourage you to stick to the long-term approach. It may not be as exciting but it gets the job done. If you do decide to short some stocks, do all the research you can to be absolutely sure that the stock WILL go down and then use stop orders to prevent yourself from losing too much money.