Short Selling Explained

If you want to have short selling explained to you in any kind of meaningful way, don’t look to most stock investment websites to do it; a vast majority of them try to over-complicate it to the point where you blow a few brain cells trying to figure out all the technical jargon and so forth. I wanted to make this hub as a way to explain short selling stocks in the most easy-to-understand manner possible. When I first got started in the stock trading world, I didn’t have any kind of mentor or anyone walking me through the thick jungles of “investment-speak”, so I had to spend a ton of time “hitting the books”, so to speak, reading investment glossaries, and just learning all the terminology until I could get a solid grasp on the concepts. I won’t lie…the principle of shorting stocks was really hard to grasp at the beginning, but after a while, with enough “mental rehearsal” and study, you’ll grasp it and then eventually it will be second nature to you as an investor. Basically, short selling means that you sell a stock that you don’t own (I’ll explain that in a minute as well), collect the money as the proceeds from the sale, and then wait for the stock to drop, and then buy the stock back at a lower price later down the road, and then you keep the difference in the two prices (the one you sold the stock for initially and then the one that you bought it for later) as your profit from the trade. Short selling only works if the stock’s price goes down. If the stock’s price stays neutral & doesn’t go anywhere, you’re stuck with an open position in a stock that’s not doing anything. If the price of the stock goes up, you’re losing money, because you are in effect going “negative long” on the stock. As a matter of fact, most online brokerages use the actual negative sign, or the “minus”, in front of the amount of shares that you’re short. In other words, if you short 100 shares of a stock, your online position statement will read “-100” shares of whatever stock it is. But back to the basic premise of short selling. Most people will ask, “How in the world can I sell shares of a stock I don’t own?” It’s actually pretty simple; when you short a stock (and yes, “short” is actually a verb in the stock trading world), your brokerage lends you the stock that you’ll be shorting, and once you sell those borrowed shares in the open market, your trading account gets credited with the cash proceeds from the sale right off the bat. So if you were to short 100 shares of XYZ stock at $50.00 per share, your account would be credited with $5,000. That $5,000 represents the absolute most money you can make on the stock, because remember, shorting a stock means that you make money ONLY when the stock’s price goes down. So you would not be able to make more than $5,000, because the stock cannot go any lower than zero.

So anyway, you’ve entered into a short position, the brokerage has loaned you 100 shares of XYZ stock, you sole them short in the market at $50.00 per share, your account was immediately credited with $5,000 from the sale, and now you’re just waiting to see what the market will do. If your bet was right and the price of the stock drops to $25.00 per share, your position is now profitable, because those same 100 shares that you sold for $5,000 are now only worth $2,500. What this means for you is that you could simply close out your position by taking the $5,000 that’s in your account and buying back those same 100 shares for $2,500, and you can keep the $2,500 difference as your profit. Think about it: the money in your account is based on the value of those shares at all times. It’s still 100 shares of stock, no matter what the current price of the stock may be at the time. When you shorted the stock, you didn’t really receive the $5,000 as much as you received the current cash value of 100 shares of XYZ stock (which was $50.00 at the time of the sale). Again, if XYZ’s stock price drops to $25.00 per share, the current cash value of the stock is now only $2,500, but you have five grand in your account to buy the stock back with. It’s a nice position to be in, no doubt. When you finally do buy the stock back and close out the position, you have done what’s known as “covering your short”. You walk away from the trade having pocketed $2,500 from selling a stock that you never technically “owned”. How cool is that??? Again, the terminology can throw you at the beginning, but you just have to keep studying and going over the jargon until it becomes second nature. Hopefully I have done a decent job at attempting to explain short selling in some kind of understandable manner…either way, drop me a comment if anything has tickled your fancy.