Professional money managers will admit to you that it is not so easy to make money in the stock market in these current down economic times. When you see the markets plunge by hundreds of points in a day, sometimes for days at a time, you can get pretty discouraged about the old buy and hold strategy that your financial adviser has always pushed on your money in the stock market.
The good news is that you can also make money on stocks when they go down. This is known as short selling stocks. In the paragraphs below, you will learn all about this concept of how to make money on stocks when they fall in price, and you will see some real examples of how much money that you can make if you use this strategy wisely and well.
What Is Short Selling?
An easy to understand definition of short selling is the practice where you seek to make money from any decline in the prices of stocks. In other words, when you short sell, you will sell a stock that you do not own to take a negative position on the stock.
You do this with the contractual ability to purchase back the stock that you have a negative position in now at a later date for hopefully a lower price than the price at which you sold the stock originally. When you buy stocks in the traditional manner, you seek to buy them low now and sell them later higher. When you short sell, you sell high upfront and try to buy back lower in the future.
Why Does Short Selling Make Sense in General?
Stocks do not simply go up, as you might hope and believe. In fact, they move up and down when the economy is normal, most of the time. When the economy is in a struggling place, as it is these days, they often have more moves to the downside than they do to the upside. With a short sell strategy, you can not only speculate on continued economic hard times and uncertainty, you can also hedge your long stock positions against declines in the overall markets.
In Practice How Do You Short Sell A Stock?
When you short sell a stock, you first borrow the shares from your stock broker. You then sell the shares on the open market, and the stock brokerage credits the funds to your brokerage account. You show a negative position in the stock at this point. So if you short sell 100 shares of IBM at $100 per share, then you receive $10,000 in your account, but you have a -100 shares position of IBM in the same account.
When you are ready to close out the trade, you cover the position when you buy back the hundred shares of IBM on the stock market. If IBM shares declined to $85 per share, then you could buy them back for $8,500 from your original proceeds. You would then zero out your -100 shares of IBM, and this would leave you with a $1,500 profit, or a fifteen percent return.
Example of Companies that Are Especially Good Candidates for Short Selling
In the days of the bygone Internet boom, there were literally hundreds of stocks that never had a chance at turning any profits. Yet despite this fact, many of them traded for hundreds of dollars per share. These were companies who were valued based on the number of hits on their websites, or the number of eyes that looked at their individual pages. They had no sound business plan to make money.
If you find a company like this, it is a good chance that it will decline in value eventually. CMRC, or Commerce One, is one such example of a stock that traded at more than $300 per share. The company’s filings clearly showed that it would never make a dime in profit. Had you shorted it at the peak of the Internet bubble in stocks, then you could have bought it back for under $20 a few months later.
One hundred shares shorted would have grossed you $30,000 upfront, then you could have bought them back for $2,000 and covered your short sale. This real life example would have made you $28,000, or a staggering 93% return, in under a year. Today the same CMRC stock trades for under a dollar, which shows you how difficult it can be to know at what point you should close out your trade and book your gains. Still, it is a good problem to have.
How Can You Know When to Short Sell A Stock or Market?
One indicator that you can watch to know when to short sell a particular stock or market is its fifty day moving average, also known as its 50 DMA. When a stock or market drops below its 50 DMA, it commonly breaks down technically and declines.
You would ideally wait for the stock to rally back up towards its 50 DMA before you shorted it, so that you could close out the trade for only a small loss if the underlying stock rallied back above the 50 DMA. If the 50 DMA resistance holds, then you have a very nice set up for a profitable trade that does not entail much risk.
Is Short Selling Riskier than Buying and Holding A Stock?
Technically the risk that you take on when you short sell a stock could be higher than when you buy and hold a stock, since the most that you can lose when you buy and hold a stock is 100% of your original investment. In practice though, you set up a stop loss order on your short sell investment to determine the point where you will get out of the investment if it moves too far against you.
This means that in practical terms, the risks to buy and hold a stock or to short sell a stock are the same. In a down economy or bear market though, the odds favor you, as the market is in a broadly lower pattern with downward momentum. The key to manage your risk with this type of short sell trade is to remember to place your stop loss orders that limit your loss when you arrange the investment in the first place.
Make More Money with Short Sale Trades than with Traditional Stock Trades
Short sale trades can make you a huge amount of money in a small amount of time. This is because when stocks start to fall, they can fall at a breathtaking pace. You have probably never heard of a buying panic. Selling panics that knock a stock down even from 30% to 50% in just a few short weeks are not uncommon.
When the markets are in this near constant state of fear and panic these days, do you think that it is easier to make money when you are long stocks or when you are short them?
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