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Short Selling For Dummies

Time to switch gears from long-positions and get into the logistics of an interesting investing strategy called short selling. Some may call it unethical because you are looking for the company decrease in value, while others feel it is a savvy investing strategy.

The first step to shorting a stock is to borrow money from a broker. You are being loaned money to buy shares of a company. You are buying this stock on margin, thus creating financial leverage. However, there is a catch: you will have to eventually return the shares to the broker.

Next step is to sell the shares immediately to the market. Then you look for the stock to decrease. You make money off a short sale if you buy the stock at a lower price than you originally sold it for.

Example:

Let's say you have a hunch that Company Z will have a poor earnings report next week. You give your broker a call and request to short the stock.

Your broker buys 100 shares of Company Z for $100 each off someone who already owns them, on the condition that you will return the shares.

Value of holdings: 100 * $100 = $10,000

You offload these shares to the market and have $10,000 in your account.

Your hunch is correct. Poor earnings report and a manufacturer defect leads to a 40% decrease in market value. The stock drops to $60. You decide to buy back the stock based on its new price.

Value of holdings: 100* $60 = $6,000

You only have to pay back $6,000 the current market value.

Profit: $10,000 - $6,000 = $4,000

In this scenario, you made a large chunk of money. This is not always the case. Say the earnings report had been stellar and the stock increased by 40%, you would be on the hook for an additional $4,000. The downside to short selling is limitless. The stock can go up exponentially. If you invest traditionally, the maximum loss you could sustain is losing your initial investment.

A portfolio manager will consider a "short" as a negative weight on a stock. Managers will short stocks in an effort to hedge their long positions. Depending on the specific investment strategy a manager may employ (i.e. Beta Neutral portfolio), holding short positions can come in handy to diffuse the risk of the overall portfolio.

Short-selling is a savvy tactic if you really believe a stock is overpriced or a market correction is looming. This will drive down the value of the stock and if you short it at the right time, you will come away successful.