3-06 Short Selling
So far, we’ve talked about how to make your first trades – buying a stock you think will get more valuable.
But what about if you are SURE a stock is about to tank? Wouldn’t it be great if you could make profit in both directions? With short selling, you can!
What Is Short Selling?
“Selling Short” is a way for an investor to earn a profit when a stock’s price goes down. It requires you to trade “on margin” because it involves borrowing from your stock broker.
Here’s how it works:
- First, you borrow a share of stock from your stock broker. Now you owe them 1 share of stock back.
- That share of stock is IMMEDIATELY sold on the market, and you get the cash. Brokers do not let you withdraw this cash, it is held against your margin requirement for the stock you borrowed.
- Some time later, you buy back that share of stock, and return it to your broker. This is known as “covering” your short.
To actually make these trades, you would “Short” the stock instead of buy, and “Cover” instead of selling. When you look at your portfolio, it would show that you own a negative number of shares.
How Does Shorting a Stock Make Me Money?
In that transaction above, you borrowed one share of stock, then returned it to your broker later, good as new. You can earn profit by short selling if the price you sold the stock for is greater than what you paid to buy it back.
For example, consider stock ABC – it is currently $100 a share, but you feel like it is about to go bankrupt. So you borrow ABC and sell it for $100. Two weeks later, you were right – they announced some terrible finances, and the stock’s price plummeted to $10 a share. Now you pay $10 to buy it back and return it to your broker.
You earned a nice $90 profit – the $100 cash you sold it for, minus the $10 it costed you to buy it back.
Risks With Shorting
When you buy a stock and own it in your portfolio, you have a very specific amount of risk, but potentially limitless rewards.
For example, if I bought Amazon (AMZN) stock in 1998, it would have cost me about $5 a share. The most I could lose was that $5 if Amazon went bankrupt. However, the price is now over $3000 – over 600% return on my investment. The price can continue to go up – there is no “cap”.
But it is the opposite with short selling. In 1998, imagine if I thought Amazon had a dumb business model and would go bankrupt any second. If I short-sold 1 share of Amazon stock, I get $5 cash – this is my maximum profit. However, my losses are unlimited – if I never “covered” my short, today I would have LOST over $3000 on that single share.
A lot of people talk about how risky shorting is, but the reality is that the only difference between shorting and buying on margin is that if you short a stock it can go upwards to $1,000s of dollars, but when you buy a stock the most it can down is to $0.00. So, when you buy on margin you know that the most you can lose is the value of the stocks you bought, but when you short stocks you could technically have unlimited losses if the stock goes to infinity!