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Selling Short: How to Bet Against the Market

This past week was action packed with lots of ups and downs in the market.  With these wild swings, I must be able to profit when the market falls and when the market rises.  Selling Short is a way to bet against a stock and make money when the price goes down.  It is not an easy concept to understand but I will do my best to explain it.

Sell Short:  Bet Against the Market

In a typical ideal stock trade you would buy 100 shares XYZ for $10 and sell it for $20.  You would make a profit of $10 per share or $1,000!  Simple enough and I think we all understand this most basic concept of buying low and selling high.  But what if you think a stock’s price will fall?  Should you avoid the stock and look for another opportunity?  Or you can bet against the stock and try to profit from the loss in price.  I will start by explaining the process and then explain the risks.

Sell Short: How to

So let’s say that stock you just cashed out for $20 per share starts to fall in price.  You would go to your brokerage and select the stock symbols like any other trade.  Next, select the transaction type or action.  We are all familiar with the buy and sell but, today, we will use the other options, “short sell” and “buy to cover.”

For your action select “Sell Short” this will tell your brokerage to sell 100 shares of XYZ on the market and give you the cash, lets say they were still $20 the brokerage would give you the $2,000.  You now owe your brokerage 100 shares of XYZ.  You have borrowed the shares from your brokerage and you will need to return them.  It doesn’t matter if you return the same share or some different share as long as you return the same amount of share. If you lend a friend $20 with a $20 bill you are happy to get paid back whether it by 2 $10’s or 4 $5’s.  As long as you get the $20, you are good.  The same concept applies to the brokerage; as long as you return the shares, they are happy.

As the price of the stock declines to $10, you will execute another trade.  This time select “Buy to Cover,” do the same 100 shares for $10 each and you will buy the stock back for $1,000.  The shares will be returned to the brokerage and you are left holding $1,000 in profit!

The Recap

Get it? Borrow shares and sell them, you hold the cash.  When the price drops, go buy them back and return the shares to the brokerage you borrowed them from.  The difference in price is yours to keep!

Sell Short: The RISK

When you execute a normal trade, also referred to as a “Long” trade, your losses are limited to your investment.  For example, if you buy 100 shares for $10 each you are invested for a total of $1,000.  If the stock goes to zero you lose that $1,000.  On a short sale there is no upward limit, so if you “short” a stock worth $10 and it goes to $20, you lose your investment of $1,000.  If the price goes to $25 you are actually in the hole for an additional $500.

There is a horror story of a man who invested $38,000 into a short of a failing pharmaceutical company.  The same day they were acquired by a larger competitor and price skyrocketed over 800%.  This man was on the hook for not only the $38,000 he put in, but also $250,000+ in additional losses.  So, if you decide to do any short selling, make sure you put a safety stop in place.  If you don’t know how to set a safety stop, you don’t need to be shorting any stocks.

My Play

On 4/3 I made the following transactions:
Sold Short 200 share of TCS for $5.70 each, total cash received $1135.00
Bought to Cover the same shares for $5.63 each, the total cost of $1130.95

I pocketed the difference $4.05 about 0.3%.
As my first short sale I can’t complain, I turned a profit and added another tool to my toolbox.

 

Check back next week for a recap of all the trades I’ve made over the past few weeks, I made more than I lost!

Thanks for reading and happy trading!

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