Short Selling Stocks for Beginners

By Ken Mueller

Short selling is a way to make money if the price of a stock is falling.  The farther the price falls the more money you make.  If for example Cisco Systems (CSCO) comes out with a nifty new internet router that takes even more business away from the phone companies you might want to buy some CSCO.  But why not take advantage of AT&T’s (T) pain too by short selling T as well?  Another common example of such a strategy is when the price of oil spikes higher is to buy some Exxon Mobil (XOM).  Then you can also take advantage of the airlines pain from the higher fuel costs by shorting Continental Air (CAL).  I wouldn’t suggest shorting Southwest Airlines (LUV) because they are masters in the energy futures markets, but that is beside the point.  You can also short any stock that has risen too high too fast.  Stock prices don’t go up forever just like trees don’t grow to the sky.

To sell stocks short you must have a margin account at your brokerage firm.  A margin account allows you to borrow money and stock from your broker up to a predetermined  amount.  Almost anyone who has a decent credit record can qualify for a margin account.  Along with being able to short stocks you can borrow up to 50% of your portfolios value to purchase more stock(s).  You pay interest on the borrowed money but it gives your account 50% more fire power when needed for quick trades.

The best way to understand the mechanics of a short sale is to think of a normal trade done in reverse order.  In a normal stock trade you would buy the stock, hope the price rises and then sell it and keep the profit.  In a short sale you would sell the stock first, then hope the price drops and then buy it back at the lower price.  You keep the difference as your profit.  Yes, indeed you sold something you didn’t own, bought it back at a lower price and kept the difference.

The reason you can sell something you don’t own is because you first borrow the stock from your broker.  There is a charge for this service but it is reasonable.  When the stock is sold the cash from the sale goes directly into your account.  When you buy the stock back, hopefully at a lower price, the cash is taken from your account.  This buying back is called “covering your short”. 

Taking Advantage of Short Sellers

If a stock is heavily shorted it means that a lot of investors have short sells on it because they think the price will continue to drop.  If then some good news comes out from the heavily shorted company and the stock price begins to rise the “shorts” panic.  The more the stock rises the more money or profit they are losing!  This causes them to “cover” or buy back their stock as fast as they can.  When this happens it is called a “short squeeze”.  The increased buying caused by the shorts covering causes the price to rise even faster.  Panic ensues and the profits are squeezed out the shorts hands and into the accounts of savvy investors like yourself because you had the good sense to buy a heavily shorted stock.  Sometimes the number of shares being sold short is as high as 30% to 40% of the float (all the shares on the market).  That is a heck of a lot of buying power that come on the market in a very small time.  The price rise in a short squeeze can be quite dramatic.

The Risks to Short Selling

The main to be risk to be remembered is that the amount of money you can lose is unlimited. In a normal trade the stock price can go to zero and you would lose all of your investment.  That is the limit of your risk, your original investment only.  However a stock’s price can rise in value two, three, four, even ten times the price you entered your short trade at.  This worst case would result in you losing ten times your original investment!  A stop loss order on a short sale is essential.

Another down side to selling short is that if a dividend payment comes due, you pay it.  Since you borrowed the stock from your broker he is entitled to the dividend.  And of course there is the fee to borrow the stock in the first place. 

To eliminate all of the risks mentioned above you can buy a put option and make the same amount of money on a falling stock price.  Stock options are beyond the scope of this article but will be covered at www.PlainLanguagePlace.com in the future.

Mutual Funds that Sell Short

If you would like to take advantage of a falling stock market and selling stocks short yourself is not your cup of tea then have a mutual fund do it for you. I would recommend beginning your search at http://bearmarketcentral.com/mutualfunds.htm   These funds specialize in bear market investing.  Before investing be sure you understand the overall trend of the market has been upwards for many many years.  Short term investing in bear market mutual funds is recommended.

An easier and more nimble way to short the market is to buy ticker QID. This exchange traded fund (ETF) makes money if the top 100 stocks on the NASDAQ fall in price.  QID is ticker for UltraShort QQQ ProShares that seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the NASDAQ-100 Index.  This fund uses leveraged (borrowed money) techniques to achieve its goal so extra caution is advised as moves can be dramatic.  On February 27, 2007 there was a major stock market sell off. The DOW was down 3.29%. The NASDAQ was down 3.86%.  QQQQ (The Nasdaq 100 ETF) was down 4.11%.  Which shows that shorting the Nasdaq 100 is usually the best choice because of the volatility in the tech stocks.  QID was up 9.5% that same day!

Finally, the opposite of being “short” a particular stock is called being “long”.  If you are bearish about a stock and think the price will drop you should short it.  If on the other hand you are bullish then by all means “go long”.