Short Selling, An Important Technique

Selling a stock “short” is a common method to making money when the price is dropping. Here’s how this works in practice. When you believe a stock is going to drop the first thing you need to find out is whether or not shares of the company can be borrowed. This is done through your broker. You will then place an order with your broker to sell shares of stock that you don’t actually own. When you place this order, you will technically “borrow” the shares from someone else. At some point in the future you will have buy those shares you have borrowed and thereby return them to the party who lent them to you.

If the stock price drops you will make money. If the price rises you will lose money.

Often an example helps with understanding. Let’s say Jane believes that XYZ Co., whose shares are currently trading at $100, is too high. Her research tells her the price of those shares should only be $80. Once the market realizes what she has just figured out the stock price of XYZ Co. will drop from $100 to $80. Jane doesn’t just want avoid this loser stock by not buying it, she wants to profit from the adjustment when the stock sells off.

Jane finds out that the stock is available to be borrowed. She then places an order to sell 100 shares of XYZ Co. at $100. She has now borrowed 100 shares from John and sold them in the market to Barry who thinks the price will rise. For purposes of this example do not worry about John or Barry.

Jane has $10,000 deposited into her brokerage account from the sale. Remember at some point Jane has to return the borrowed shares to John. To do this she will need to repurchase the shares in the market.

One month passes and low and behold Jane was right, the stock dropped from $100 to $80 per share. Jane wants to close this trade and take her winnings. Jane will enter an order to buy 100 shares of XYZ Co. in the market at the current price of $80 per share. Jane has $8,000 drawn out of her account. She has now made $2,000 ($10,000 - $8,000 = $2,000).

Of course, Jane could have been wrong and stock price could have risen. Let’s say she sold 100 shares at $100 but has to buy those shares back at $120. Jane loses $2,000 ($10,000 - $12,000 = -$2,000).

Short selling is not easy to do. The above examples are simplified. They do not take the interest you have to pay to the lender of the shares into account. The longer you are in the trade, the more interest you have to pay. Additionally, market conditions have to be just right. You have to move quickly, know where to enter the trade and where to exit the trade. In our opinion short selling is not for the novice investor. Perhaps in time though this is an avenue to make some money in a down market.