Stocks: Shorting

There's more than one way to skin a cat. And, there's more than one way to make money on a stock.

Selling short is a way investors make money on stocks that they believe are going to decline in price in the near future. The important thing to remember: Shorting, while offering a smart way to make bearish bets, carries significant downside risks.

To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his or her troubles. For example, you borrow 100 shares of XYZ Co. at $100 a share from your broker, then sell them for $10,000. Let's say the stock drops 20% to $80 a share; you buy the shares back for $8,000, then return them to your broker and pocket your $2,000 profit (minus your broker's commission and interest, of course).

Now, let's examine the other side. If you short a stock whose price rises, things can get hairy. You can either wait to see if the stock will decline, which means you rack up hefty interest costs; or, you buy the stock back at a higher price than you sold them, and give them back to your broker (along with the other fees), and take the loss. Covering your short position at a loss can get ugly during a short squeeze. A squeeze occurs when a stock that has been shorted by many investors rises. More and more short-sellers must buy shares to cover their short position, putting greater upward pressure on the stock price.

The Short Report

If you want to know the skinny about shorting stocks, look no further than the link below, which comprises a six-part series on shorting by James Cramer.

Cramer's Short Report

For additional stories on the subject, consider:

What Do I Need to Know About Shorting Stocks?

Shorting Requires Solid Facts, Not Anger

Shorting Tech Stocks

Going Long the Short List

Getting on the Short Side of Frothy Stocks