Selling Stock Short – Who Sells Short and How they Profit From It

October 13, 2008

Selling stock short has been in the news a lot recently since stocks across the board have been dropping in price and many speculators have found it a good opportunity to make some money.

Short Selling Example

Short selling is based on the fact that people believe the price of stock will go down.  It is easiest to explain with an example, so let us say a short seller thinks company ABC, which is currently at $40, will drop in value.

They could borrow shares of stock from their broker, sell them for $40, and deposit the proceeds in their account.  Then, if the stock price goes down, say to $30, they buy back the number of shares they borrowed and return them to their broker.  They just made $10 a share, using “borrowed” stock.

Risks of Selling Short

Of course the risk is that the price will go up and the short seller will have to buy back stock at a higher price and lose money.  Although the upside is limited to the difference between the stock price when they borrow the shares and $0; the downside is potentially unlimited.  The higher the price of the stock goes, the more money the short seller can lose.

There is a tool that short sellers can use called a stop loss order that triggers a stock buyback once the price goes above a certain point. Although it will force them to lose money, the stop loss order will limit the loss.

Short Selling Strategies

Some investors use short selling as a way to offset the risk that stock they already hold will go down.  For example, if they own 100 shares of company ABC and are concerned the stock price will drop, they can borrow a certain number of shares of ABC and sell them short.  If the stock price plummets and their 100 shares lose significant value, they will recover some of that from the short sale.

Other people sell a stock short simply because they sense an opportunity when a company’s stock price is faltering.  Over the last several weeks, when many stocks have been dropping, some traders have used short selling to their advantage.  There are claims that short selling contributed to the drastic drop in share price of some of the bank stocks. 

The government put a ban on short selling for a few weeks in September to prevent short selling from further eroding the stock market value but that ban has been lifted.  If you are thinking of selling a stock short, make sure you’re aware of the potential fees you have to pay the broker and what you are at risk of losing if the stock price goes up instead of down.

Ben

Will this article help you save or earn more money? Get others like it simply by entering your email address below. Your email is used only for delivering daily money tips and you can opt out of delivery at any time. Click here to see all your free subscription options.

  

Ben

Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn’t like the other kids… His addiction to personal finance has paid off for his family and now he’s helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.


All posts by

Comments

3 Responses to Selling Stock Short – Who Sells Short and How they Profit From It

  • market folly

    good idea to write a post explaining this type of stuff to the public, because surprisingly a lot of my friends (and american public in general) had no idea what it was or how/why it is used.

    -Jay from marketfolly.com

Trackbacks/Pingbacks

  • linklings, opportunities abound edition | brip blap
  • Red Sox Lose Game 7 = Ouch (and weekend links)