We all know that when you buy stocks, you make money when their prices increase. That’s pretty much stock investing 101. However, stock investing 102, the class right after, will teach you that you can also make money when the price of a stock is falling. Yeah. It’s rudimentary, but if you don’t know about it, you’d be amazed. Many times, you make More money when a stock is falling than even when it’s rising, provided that you call the decline correctly. How does this work?
It’s a simple trick called shorting or short selling.
This is where you ask, what the fuck is that. I’ll spare you the Google: Shorting or short selling a stock is a trade you make when you think the price of an asset is going to go down. You borrow an asset and sell at its current price, wait till it falls down to the price you think it’s going to decline to, then buy it back and return to the owner (known as closing or covering the short). Let me explain the logic in more everyday items: iPhone. You know, as Apple fanboy or fangirl, that Apple is coming up with all sorts of gizmos in its new iPhone which is launching soon. And like a true fan, you know this way before most people do. You also know that once that new iPhone drops, the 6S that is selling for $700+ right now is going to fall to under $500. So you come borrow a brand new iPhone from someone who stocks them, with the promise that you will replace it within a specified period. You then sell the iPhone for $750, then wait two weeks for the new one to drop, and buy it back for $550 and return it. You’ve just made $200 in two weeks. Not bad.
That’s exactly how short selling works. You usually borrow the stock from a market maker or your broker through your account, sell it, and then buy the stocks back once the price has declined to cover the short. I’ve done it a few times, myself. However, over time, I came to see short selling as something you should not do purely by itself unless you’re extremely sure of the outcomes. Because while you can make a whole lot of money doing shorts as George Soros demonstrated . But if it goes bad, it can go spectacularly bad, and your risk is unlimited. Right now, I can only use shorting as a hedging strategy, where it is used to lower the risk of another trade. Naked shorts (that is an unhedged or straight short sales), will mess you up.
I’ll elaborate on that in another post. In the mean time, learn all you can about shorting, and how to do it properly. It’s useful for any would be investor.