Except with the most experienced traders short selling or shorting a stock is a strange concept.   However, more traders should learn how to short sell because it can be a very profitable way to trade, especially in a bear market.

Most traders or investors think of stock trading as “going long”, i.e. buying stocks in the anticipation that the price will rise and they will make a profit.

Short selling is the opposite.  You profit from the decline in the price of the stock or bond.   With shorting you are basically borrowing the stock to sell it.  If the price decreases the short seller can buy the borrowed stock back at the lower price and pocket the difference.

Say XYZ Company stock is currently being sold for $10 per share. As a short seller you can borrow 100 shares of XYZ (or more depending on your capital and risk tolerance) and sell them immediately for $1000.  If the price of XYZ stock to say to $5 per share you would buy back 100 shares at the lower price.  You give back the 100 shares to the owner of the stock and make a $500 profit.

However if the shares of XYZ rise in price say to $20 then you would have to buy back the 100 shares for $2000 and you would lose $1000.

Short selling is often considered to be a positive market force. An important point to consider is that an investor involved in short selling may be prone to a short squeeze.

SHORT SELLING BASICS

  • You can borrow shares based on shares up to 50 percent of the shares value. So you must deposit 50 percent of the shares value in cash in your brokerage account.
  • You sell the shares and the proceeds are credited to your account at the brokerage firm.
  • You must “close” the position by buying back the shares. This is referred to as covering.  If the price drops, you make a profit.  If it rises you take a loss.
  • You return the shares you borrowed to the lender.

When to Sell Short

Sell short only during what you believe is a developing bear market, not a bull market. Bear markets occur about once every three years, and when they do, the decline occurs at a much faster pace than previous rise. In a bear market there are only two things you can do: either sell most or all your stocks and get out, keeping your money in cash or money market funds, or short sell stocks.

It is best to time your short selling with the action and movement of the general market averages. After they show definite signs of weakness, only then does it become a question of the selection and timing of the individual stocks to sell short.