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What is short selling a stock? Basically it is betting that the stock will do what you usually would rather it wouldn’t; go down. Typically investors want to see their stock picks rise in value. With short selling, however, you make money when the stock falls. It’s great for companies or sectors that are experiencing trouble. You could have made a mint short selling Bear Stearns for example. The same would have been true for some of the mortgage industry stocks that collapsed in the last 6 months. When there’s a bear market, short selling is one of the ways savvy investors make their money.

So, how does it work? How can you actually profit from a company’s troubles and it’s stock price’s decline. Short selling works like this. First of all, with short selling, you don’t actually buy the stock, it’s on loan from your broker. When you make the transaction, the stock is sold and you receive the proceeds from the sale. They are deposited into your brokerage account. Sweet! You just got money in your account from a stock you didn’t even own.

Not so fast there, Warren (whose standard investment strategy, buy value stocks and hold for long term appreciation, is the opposite of short selling). At some point you have to repay the money the broker loaned you. Actually you have to repay the shares, and that’s where you make your money. In investor parlance, getting out of your position and repaying the broker is called “closing the short”. If, for example you borrowed to short 100 shares of Bear Stearns in mid August of 2007. The stock was trading for around $120 a share then. You are then liable to repay 100 shares at some point in the future. If you wanted to cash out for Christmas, you could have gotten out for $89 a share. You would purchase 100 shares at $89 each to repay your broker. The difference between the price when you borrowed and when you repaid is your profit. In the example you made $31 a share, for a profit of $3,100.

Not bad at all, but as we know now only a small fraction of what you could have made. Holding until today would have gotten you a much tidier profit in the neighborhood of $115 a share, for $11,500 in gains. This little example illustrates the potential of short selling, but it also shows one of the problems. One of the problems associated with short selling is risk. A well run company may not fall, especially in the long term. You have to get out when the stock’s price is lower than when you borrowed.

The other big disadvantage, especially over the long term, is that you are limited in your total profit from short selling. The most money you’ll ever make is the difference between the price when you got in and zero. For a short seller, that’s a best case scenario. Cases like Bear Stearns, where a company goes from selling for well over $100 a share to virtually zero in a few months, are pretty rare. Typically you’ll get returns of far less, and if the stock does turn around, you’ll have to repay the shares at a higher price than what you got them for.

Short selling is usually not for the novice investor, although you could have made a nice profit by short selling financial services stocks over the last 6 months, novice or not. Have a great day, and stay Debt Free.