Shorting a Stock – Learn how to make money when the market goes down!

Not very many people are familiar with shorting a stock. You probably are familiar with buying a stock (go long). This is where you actually purchase the security for the current trading price with the anticipation that it will go up and you will make money if you sell it for a higher price. Shorting the stock on the other hand is when you borrow a security from your broker and sell it with the hope that it will go down and you can buy it back cheaper and make money.

Shorting a Stock

XYZ Stock is currently trading for $18.79, you think the price of the stock is overvalued and will go down rather than go up and you want to take advantage of the price action. So shorting a stock means you enter a Sell Short order with your brokerage. The brokerage then goes out and borrows those shares from another client that has a margin account and delivers them to you in order to sell. So you sell short 1000 shares for at total trade of $18,790.00. Your account will get a credit of $18,790.00 minus any commission. The price goes down to $15.67 and you decide to buy to cover your position. So now you go out into the market and buy 1000 shares at $15.67 or a total trade of $15,670.00 plus any commissions. The shares are then delivered back to your brokerage and you get to keep the difference between what was deposited in your account $18,790.00 and what you had to spend to buy to cover $15,670.00, which is $3,120 minus any commissions. This would be considered your profit for shorting the stock.

Let’s walk through this a little different way to help you get a better understanding on how shorting a stock works. You and your brother-in-law decide to do a trade with each other. I don’t necessarily recommend that you trade with your brother-in-law. But if you had to take the trade, here is how it would work. You have been watching ABC Company and decide that it is overpriced, so you would like to find a way to make money if the stock goes down. You can do this by shorting a stock. So you go to your brother-in-law and ask him if you can borrow 100 shares of ABC Company. He says yes, but he tells you that you have to pay him back 100 shares of ABC Company. You take the shares to your broker and sell the stock for $18.00 and you pocket $1800. You were right and the stock went down to $10.00, so you called your broker and told him to buy you 100 shares of ABC Company. It cost you $1000 to buy the stock back. Then you strolled happily back to your brother-in-law and gave him his 100 shares back, with a little smirk on your face. So what just happened? You sold the stock for $1800 and were able to put that cash in your pocket, and then you bought the stock back which cost you $1000.00 out of pocket expense. The difference is $800 that you got to keep in your pocket. This is the profit you made for shorting a stock.

This example sure makes shorting a stock sound easy. Has anyone told you that there is no free lunch, there is a catch to shorting a stock. When you buy a stock you only risk the money it cost you to buy it. For example, let’s say you bought 100 shares of a stock for $23.00 it cost you $2300.00. That amount is the most that you could lose if the stock went to $0.00. Shorting a stock on the other hand could cause you to lose an unlimited amount. Here’s why. If you go out and borrow 100 shares of stock at $50.00 and sell it, with the understanding that you have to give 100 shares of that stock back at some point in time, then you could theoretically lose an unlimited amount of money if the stock went up forever from the point of you shorting the stock. Let’s explain this statement with some numbers. You sold the stock short at $50.00, if you had to go out and buy the stock back for $350.00 per share then it would cost you $35,000.00 and you only received $5000.00 for your $50.00 sell. This amounts to a loss of $30,000.00 Ouch!!!!

There is another variable that comes into play when you are shorting a stock. Since you are borrowing securities and selling them you will have to have an account that has margin. Margin is the account trait that allows you to borrow against the securities you have in the account. The brokerage company will charge you an interest rate to lend the money against your securities. Margin accounts have a margin requirement, typically 50%, that you cannot cross or they will require you to deposit more money or sell some securities. This is a pretty easy trait to have put on your account by your broker. Some accounts already have this checked when you open the account. The biggest reason for not having a margin account is the potential for more risk. As you learn to trade you may want to minimize your potential for risk. The second reason for not having a margin account is the additional risk you take when the brokerage company hypothecates (when you use an item as collateral to secure a loan) your securities. Now you do not own 100% of your securities and if the brokerage company goes under there is a possibility that you could lose your stocks that are margined. The biggest problem with this is that you may not have wanted to sell or buy the stock at that point in time.

Selling short definitely has it pros and cons. As a trader it is important that you gain a solid understanding of how shorting a stock works. There are times in the market when it does not go up and you will need this strategy if you want to make money trading.

Share on FacebookShare on Google+Tweet about this on TwitterShare on LinkedInIt's only fair to share...