The Long and Short of Shorting

Investors are taught to buy and hold stocks and other investments.  We are conditioned to make profits in the markets as they move upwards in price.  However, when someone buys a stock don’t they need someone to sell it to them?  Who is doing all of this selling and what is in it for them?   More importantly, is there a way to profit in the markets when prices drop?

The answer to all of the above is short selling! Short sellers can offer added liquidity to the markets, their selling orders match the buying orders of others and allow transactions to happen.  And short selling profits when the prices of securities fall.

What is short selling?

A short sale occurs when a trader sells or promises stock to a purchaser without owning any of said shares.  How can a trader sell something they do not actually own? Isn’t that fraud?  When you sell stock, you actually have to have shares to sell.  When you are selling shares you do not own, you are selling shares that you have borrowed.  When you open a margin account with a broker, they not only allow you to trade with leverage but also will lend you shares that you can use for short selling.

The process that occurs when you short sell is that the broker allocates a certain number of shares from their own inventory or from the account of one or more of their customers.  They lend these shares to you so you can sell the shares to someone in the market.  You are responsible for returning the shares at some point in the future.  The money you collect from selling the shares and a deposit from your account is held by the broker until the conclusion of the trade.

Should the shares drop in value after you shorted them, you can buy them back in the open market for less.  When you give the shares back to the broker, you keep the difference in the price of where you shorted and where you bought.

Let’s imagine that you believed that the price of Apple (AAPL) was moving up into a Supply Zone.  You could borrow 100 shares from your broker and sell them for a total of $15,620 (100 shares x $156.20 per share).  If you are correct and the price falls, you are able to replace the borrowed shares by buying them back a few days later for only $15,000 (100 shares at $150/share).  The broker only wants you to replace the shares, you get to keep the extra $620!

We are programmed that buying low and selling high is the way to make money in the markets.  But smart traders know that with short selling you do not have to do the buy first.  When prices are high, you are able to short them and profit from selling high and buying low.  The key is knowing when prices are too high and are ready to drop and how far they are going to drop.

To learn more about how shorting works, come visit your local Online Trading Academy center and enroll in a workshop today!

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