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Selling Short - Profit From the Downside

Selling short enables you to make money in a declining market. Selling a stock short means that you sell a stock that you do not own and collect the proceeds of the sale. You then wait for the stock to decline in price at which time you buy the stock back at a lower price. Your profit is the difference of the proceeds from the sale minus what you paid out to buy back the stock, your commissions, interest paid on the margin account and dividends you had to pay.

The mechanics work like this. When you sell a stock short you don't own the stock, so you "borrow" the stock from a pool of stock held by the brokerage firm. You are obligated to replace the stock at some future date. To fulfill this obligation, you buy back the stock thereby placing it back into the broker's inventory. Buying back the stock is called "covering your short" or "closing out your short position."

When a stock's price moves to the upside, short sellers begin to buy back their shorted shares. As more and more short sellers enter the market to cover their short positions, a "short squeeze" occurs, further driving up the price of the stock.

Because you did not own the stock you sold short, and you borrowed shares from the broker, the sale proceeds are placed in a margin account. Therefore, you pay interest and fees on the amount and pay the dividends for dividend-paying stock. And you must meet the margin requirements until you buy back the stock.

Shorting Example

Assume you sold short 100 shares of stock XYZ at $80 per share. After commissions you brought in $7,900 to your account. Because this money is borrowed money, you immediately begin to pay interest on the amount. Two months later the stock price of XYZ is $50 per share. You decide to cover you short position so you buy back the stock at $50 per share. This transaction costs you $5200. Therefore, your profit is $2,600 ($7,900 - $5200 - interest of $100).

But what happens if the stock price of XYZ increases in price? If you believe the up move is temporary, you do nothing. But if you believe the price rise will be prolonged, you would cover your short position immediately. And you would buy back the stock at a higher price than you sold it. You take a loss, but you are no longer obligated to pay interest or meet margin requirements.

If the stock rises sharply, the broker may be required to demand more money to meet the legal margin requirements. The problem with selling short is you have an unlimited financial liability if the stock keeps increasing in price and you don't cover the short position.

A more conservative way to sell short is with inverse exchange-traded funds (ETFs) that enable you to make money when the market goes down. You may use these ETFs to bet against the market for a short-term trade or you may use them as a longer-term insurance policy (hedge) against the risk of a market decline. See ProShares Short and UltraShort for examples of inverse ETFs.

Use caution if you short a stock, index or any security. Be sure to talk with your broker or an experienced trader before you execute a short sale for the first time. If prices move up, your losses can add up very rapidly. Understand that prices can move against you.

See the following videos: Basic Shorting Put vs. Short Leverage


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