How Shorting Works

The profit potential from shorting is made when the stock goes

down. Just as there are uptrends, there are downtrends. Once you

find a stock in a downtrend, or if the price is extended, you have a

potential short candidate. Specifically what to look for will be covered

later. For now, let me explain the basics of shorting.

Suppose you think the price of XYZ stock is going to go down

from its current price of $32. Most people would call a broker and tell

him or her that they want to sell short 500 shares of XYZ stock. To

short stock, you must have a margin account already in place. Your

broker then borrows 500 shares of XYZ stock from an account and

sells them to you. At once, $16,000 is deposited in your margin

account. This cash earns interest, which will be discussed later. You

might be thinking, "Wow, $16,000! I love this short selling stuff."

Unfortunately, this is not the end result of short selling. Since you

borrowed the stock, you will have to return it to your brokerage firm

at a later date. The $16,000 is in fact borrowed money. Here is how you make a profit. If the stock drops to $25, you can buy back the 500

shares for $12,500, return the stock to your broker, and keep the

profit of $3,500 minus the commission. The $3,500 is the difference

between what you sold the stock for, $16,000, and what you bought

it back for, $12,500 ($16,000 - $12,500 = $3,500). You may not quite

understand yet that you made money without any initial cash outlay.

What if you are wrong and the stock price goes to $40? How

could this happen? Because you were stubborn, saying to yourself,

"It can't go any higher." The words it can't are not in any serious

trader's vocabulary. Traders know that anything can happen, and

they act accordingly. Always place a stop to cover your short position,

just as you would when going long. If you are trading electronically,

you are the stop. If the stock went to $40, you would have to

pay $20,000 plus the commission to buy back the 500 shares. Ouch!

In theory, going short has unlimited risk, because price could rise

forever. Conversely, a stock can fall only to 0, having no value after

that point. Because shorting involves unlimited risk, the SEC

requires a margin call when losses reach a calculated amount.

The profit potential from shorting is made when the stock goes

down. Just as there are uptrends, there are downtrends. Once you

find a stock in a downtrend, or if the price is extended, you have a

potential short candidate. Specifically what to look for will be covered

later. For now, let me explain the basics of shorting.

Suppose you think the price of XYZ stock is going to go down

from its current price of $32. Most people would call a broker and tell

him or her that they want to sell short 500 shares of XYZ stock. To

short stock, you must have a margin account already in place. Your

broker then borrows 500 shares of XYZ stock from an account and

sells them to you. At once, $16,000 is deposited in your margin

account. This cash earns interest, which will be discussed later. You

might be thinking, "Wow, $16,000! I love this short selling stuff."

Unfortunately, this is not the end result of short selling. Since you

borrowed the stock, you will have to return it to your brokerage firm

at a later date. The $16,000 is in fact borrowed money. Here is how you make a profit. If the stock drops to $25, you can buy back the 500

shares for $12,500, return the stock to your broker, and keep the

profit of $3,500 minus the commission. The $3,500 is the difference

between what you sold the stock for, $16,000, and what you bought

it back for, $12,500 ($16,000 - $12,500 = $3,500). You may not quite

understand yet that you made money without any initial cash outlay.

What if you are wrong and the stock price goes to $40? How

could this happen? Because you were stubborn, saying to yourself,

"It can't go any higher." The words it can't are not in any serious

trader's vocabulary. Traders know that anything can happen, and

they act accordingly. Always place a stop to cover your short position,

just as you would when going long. If you are trading electronically,

you are the stop. If the stock went to $40, you would have to

pay $20,000 plus the commission to buy back the 500 shares. Ouch!

In theory, going short has unlimited risk, because price could rise

forever. Conversely, a stock can fall only to 0, having no value after

that point. Because shorting involves unlimited risk, the SEC

requires a margin call when losses reach a calculated amount.