What Is Short Selling Stocks? Should I Do It?

Daniel Penzing
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What Is Short Selling?

Short selling is the sale of a security that an investor does not own at the time of sale. Short sale is established, as the result of a borrowed stock, by lender and borrower, with short seller receiving prearranged agreement from lender to return borrowed stock in exchange for cash proceeds from short sale. A short sale transaction can be motivated by a number of reasons including adverse capital gains tax environment, desire to invest in shares of a different company with a broker or desire to hedge existing long position.

Here's an Example

If you own XYZ stock and you think it will soon fall in value, you can short sell it. You would borrow the XYZ stock from your broker and sell it. Then, when the stock falls and becomes less valuable, you buy the stock back and return it to the lender.

Essentially, you make money when the stock price falls, and you lose money when the stock price rises. With this setup, you don’t pay any interest or fees to borrow the stock, but you can end up losing money if the trading price goes up.

Back to Those Guys From the Movie

MILLION DOLLAR BABY.

For a really quick example, let’s take a look at a fictional boxer named Million Dollar Baby. Turns out, she’s a spectacular fighter, and everyone in the world wants to watch her win. Then one day, she’s in a title fight and wins, just as everyone expected. The problem, however, is that she’s a fictional boxer created by Hollywood. The film director makes a ton of money from her victories, and she wins a lot of fights. But when her next fight’s scheduled, people start asking questions.

When people hear she’s an impossibly gifted fighter who’s undefeated, they start to doubt that she’s real. They’re just imagining it, they think. Celebrities like a big, fictional, boxer are too much of a good thing, though, so the director tries to avoid this doubt with a clever trick. He drives up the price on her stock.

Should You Try Shorting a Stock?

You have probably heard the term "short selling stocks" in some financial articles, maybe from a speech or you have heard one of your friends talking about it.

Short Selling stocks is NOT as easy as day trading or buying and holding.

In fact, making money in the stock market has a lot to do with luck and even more to do with understanding the ins and outs of the market. Unlike buying and holding a stock, short selling stocks requires specific skills as well as determination, a non-stop commitment and even a little willingness to take risks.

So what is short selling a stock?

It means selling a stock you don’t have. When you sell such stocks, you aim to profit from their fall in value. The hope is that the value will decline and as a result you can buy the stock in the future at a lower price and pocket the difference.

What Should You Do Instead?

Short selling stocks is usually the last thing you want to do if you want to be profitable long-term in the stock market. It’s a common misconception that investors can make money by simply borrowing stocks from their broker to sell in the market. You stand to make money when the stock falls. Yes, in theory you can earn quick profits when a stock suffers a sudden fall in price.

There is another way to bet on the downfall of a stock. What you do is purchase a put option for that same stock. The upside is that your potential profits are unlimited when a stock falls. Also, you will only lose the money you invested in the put option, which is typically a fraction of what you would lose if you short sold the stock. With the stock market being very volatile, it’s tough to estimate which companies will suffer losses and which ones will thrive. That’s why stocks are always in flux.

If you think a stock will go up, you must buy it and hold it for a long period of time to exploit the possible gains. A put option is another alternative to short selling stock. If you find stocks hard to analyze, put options are easier to understand.