When you sell stocks you don’t own, you sell short. That’s all there is to it. You might ask how it’s possible to sell something you don’t own and why people do this. Good questions. Let’s tackle one question at a time.
How can you sell stocks you don’t own?
Easy…..you borrow them from a brokerage firm. All the brokerage firms do this. After you borrow the shares you sell them and stuff the cash in your pocket. 🙂
Of course the broker who lends you the securities charges you interest on the transaction. And at some point, you’ll have to replace that borrowed stock.
How do replace the stocks you borrowed and sold?
You’ll buy shares on the open market at some point of your choosing and hand them over to the kind broker who lent them to you.
Why do people go through this rigmarole?
People sell stock short because they think the stock price is going to drop like a bowling ball in a pool and they want to make some hay on it. Let’s consider an illustration. (We’ll keep it simple by ignoring the trading and interest costs of selling short for now and just focus on the main transaction.)
Assume you don’t own any XYZ shares but you think it’s about ready to head south big time. You put in a “sell short” stock order and sell 100 shares at $40 a share. $4000 is neatly deposited into your account. How sweet it is……
Keep in mind that at this point you “owe” the brokerage firm 100 shares of XYZ. You do not owe them $4000. This is critical to understanding the short sale my friend.
Assume that a few weeks go by and the stars of luck shine on your happy face. The stock drops to $25 per share. At that point, you buy 100 shares of XYZ at $25 per share at a total cost of $2500. The broker debits your account that $2500 to pay for the trade. So far so good.
The brokerage company keeps the 100 shares you bought because you owed them those shares. So everything is back the way it was.
But did you notice the magic? You keep $1500. It’s yours. That’s the profit you made as a result of XYZ stock dropping in price. Pretty nifty huh? That’s the beauty of selling short when things go well.
You Can Lose Money Also When You Sell Short
Of course, if the stock price rises you will get roughed up a little. Using the example above, look at what happens if the share price rises to $50 per share after you sold short at $40.
In that case, you’ll buy back 100 shares at $50 for a total cost of $5000. Since you sold the shares at $40 for a total of $4000 you will owe the brokerage firm $1000. That’s your loss as a result of buying at $50 and selling at $40.
Why You’d Have To Be Coo – Coo To Sell Short or Buy Short Funds
Unless you have a working crystal ball the chances of making money selling short are pretty low. That’s because the natural tendency of the market is to rise. When the market sells off, it often does so quickly and unexpectedly. I have never met anyone who has successfully sold short and made money on a consistent basis. It’s just too hard to time. It’s far better to find a good solid investment strategy and stick to it.
Do you ever short stocks or buy funds that do? What has been your experience?