The concept of shorting really tripped me up when I first started investing. Before that, I always assumed the only way to make money investing, was to buy. You know – “buy low, sell high.”
But, what I soon learned was that “sell high, buy low” was also a very valid concept. In fact, once I figured this out, I knew that I was going to be able to make money regardless if the market was bullish or bearish. Of course, you still need to know what you’re doing… but in theory, money can be made in a bull or bear market; recession or crazy hot economy. Makes no difference.
But what is shorting? Short selling is the borrowing of shares from ones broker to sell in the open market, and buying those same shares back at a cheaper price and profiting on the difference. Let me explain:
Let’s assume I am bearish on company ABC (hypothetical company). I think they suck, and I think they will drop 5% in price within a week. Currently, ABC is selling for $100 per share. I want to short them, so I open a short position via my trading platform for 10 shares. When I “Sell to Open” via my broker, my broker then lends me the 10 shares I requested, and they are automatically sold on the open market for $1,000 (not including fees).
So, to recap: I borrowed 10 shares from my broker and sold them for $100 per share netting me $1,000 that is deposited into my trading account.
A week goes by and ABC stock did exactly what I thought they would – they tanked 5%. WOO HOO! What a great analyst I am! So ABC is now selling for $95 per share – $100 minus $5 (5% of $100) equals $95. I decide to close my position by placing a “Buy to Close” order.
Now I am buying back the shares that I borrowed, so I can return the borrowed shares to my broker. But, I am buying the shares back at a cheaper price than they were when they were loaned to me… so I get to keep the difference. I sold ABC for $1,000 (10 shares at $100 per share), and bought them back at $950 (10 shares at $95 per share) to give the 10 shares back to my broker. I get to keep the difference – $1,000 minus $950 equals $50. I just made $50, or 5% on my return. FANTASTIC!
The example I gave was for short selling stocks. However, there are other ways to short like buying put options. A put option… simply put (LOL LOL)… is an option contract that you purchase when you think the underlying is going to fall in price. But put options are for another article. Just know that with a put option you are not borrowing anything, rather, you are buying with your money a security that will allow you to profit when the underlying falls in price.
Understanding short selling broadened my horizon in terms of investing. With a good understanding of short selling, it is entirely possible to profit in a bear market, the exact same as you can in a bull market. But, like any other investment type, short selling carries certain risks that other strategies do not. As always, it is absolutely necessary for you to educate yourself on whatever you do BEFORE you do it when it comes to investing or finance.