There is a lot that goes into the stock market. And I am not just talking about the volume of money that is moved on a daily basis. The entire process of getting your company prepped for an IPO, as well as the logistics and the regulations that follow, is enough to make most people’s brains numb.
Fortunately, as investors, we don’t have to worry about any of that. For the most part, we just need to know that we can purchase shares of the good companies, and make some money doing it. While this is great when the stock market is looking up, there is a relatively easy way to make money when the market is on its way down as well.
What is Short Selling?
The only way to make money on a stock when its value is dropping is to sell it short. The act of short selling is pretty easy since everything is automated. The logistics behind the short sale is actually a little more complicated, but before you jump into a short sale, it is important to know how the process works.
The Sell Before the Buy
Most of the time you buy a stock, let it increase in price, and then sell the stock. When shorting a stock, you have to sell it first, and then buy it back later. The way this is possible is the brokerage firm you are using must lend you the stock before you pay for it.
For instance, you want to sell XYZ stock at $100 per share because you have a feeling they are going to drop in value dramatically. You short 100 shares, and all of a sudden you have $10,000 in your account (keep in mind your account will need to have a certain amount of cash to be used as collateral). A few days later your research pays off and the stock drops to $50 per share. You then pay for the shares that you already sold for $100 per share. So out of that $10,000 “loan” you only have to pay back $5,000. You have a $5,000 profit for knowing the stock was going to lose value.
Sound complicated? Just keep in mind that you are selling for a higher price in hopes that you will buy later at a lower price.
What are the Risks?
When you buy a stock, you can only lose as much money as you put into the purchase. When you short sell a stock, however, you can potentially lose an unlimited amount of money.
From our example above, suppose the price of the stock increased to $150 instead of dropping to $50. You now owe $15,000 on your $10,000 loan. You decide to wait in hopes the stock will come back down and the price increases to $200 per share bringing your debt up to $20,000. As long as the price continues up, you will owe more and more money on the transaction.
Final thought
Buying and selling stocks is a great way to increase your net worth rapidly. But only if you really know what you are doing. Most people do not have the time, patience, or knowledge to analyze stocks and determine if they will increase or decrease in value. So rather than learn an entire trade, mutual funds are often your best investment tool. However, if you do have some “fun” money that you are able to play around with, learning to short sell is a great way to help keep your account moving in the positive direction, even when the overall market is not.
