Profiting From Short Selling

by: Christopher Muir



Selling stock short is still kind of a mysterious strategy to most people, who normally have simply purchased stocks or mutual funds in the past. Yes, this is a paradigm shift for most people, who don't understand how one could sell an investment that they do not actually own.

Here is a brief explanation of how short selling works: you just sell a stock with the intent to buy it a some later point. You obviously hope to purchase it at a lower price, if the investment continues to go down over time. There are often restrictions on doing this in normal accounts, but you are often able to do it in a margin account. If the stock does go down, buying it at a lower price will leave you with a profit, much like if you purchased a stock and it increased in value.

Now that we have defined short selling, lets go over how it is best incorporated into a market strategy. Firstly, you have to understand that not all investments represent relevant buying opportunities. If you don’t feel that the stock has very much growth potential, it frankly doesn’t make sense to buy it. However, if you believe that a stock is substantially vulnerable – be it because of a sector deterioration, like the financials at the moment, or a specific company weakness that you have noticed – there could be a good chance that it will lose value over time. In this situation, if you were to short the stock, you would just be wagering on the fact that the stock will likely decline in value.

This can be an extremely profitable strategy - especially in down markets like this; that said, it is not without its important considerations. First of all, short selling can be extremely dangerous for those that don’t have a considerable amount of short selling experience. If you buy a stock, you could potentially lose the entire investment if the stock goes to zero; however, when selling short, you could potentially lose an infinite amount of money, since the stock could rise against you by an infinite amount.

Fortunately, there are simple ways to assuage this concern. You simply have to put a stop loss at some point above where you sold short, where if the market rises to that price you will buy and close out the short position. Yes, in this case you would loss some money, but it will be a limited amount rather than an infinite amount. The price where you place your stop loss should be determined by the level that you would not feel that the investment to still be a good shorting opportunity. For example, if you sold Microsoft at $5, you may feel that if it went to $10 then it no longer would represent the appropriate level of vulnerability. You would thus place your stop loss at that amount, strictly limiting your total risk.

Another question is one of ethics. Some people have a moral issue with selling short, feeling that you are capitalizing from betting against the economy; or for the more nationalistic, betting against the USA. In many ways, this is true – you are betting that the stock is going to go down in value, but how is that immoral? It isn’t you that is forcing the stock down – it is the poor fundamentals of the firm or specific sector that will cause its price to decline in the long run. In fact, one could make the argument that selling short helps to move problematic investments closer to the fair market value. For example, if a firm is flawed – but is still being priced high – it is the function of short sellers to sell that stock, allowing it to move towards its fair value faster, where buyers will then be there to support it. Those who wrongly impose their ethics on natural market dynamics entirely miss the point.

Lastly, you should realize that the equity market isn’t the only opportunity to produce returns from the decline of prices. You can also sell futures short or sell various forex pairs against one another, both of which are generally much simpler to do than short selling stocks. You could also look into professional investment firms who sell short as a component of their financial strategies. Unlike regular mutual funds, a lot of alternative investment managers have elements of short selling in their investment methodologies: some are pure short sellers, and some do both short selling and buying, depending on the market conditions.

You should, however, at least learn more about the concept of selling short more closely, as it can be extremely profitable if you have a sound strategy. Traders like Jim Rogers have made lots of money from merely purchasing investments that are strong and short selling the things that are bad. In a recent press release Rogers disclosed that lately he has simply been buying the commodities (which he believes to be fundamentally sound) and short selling the financial stocks (which he believes to be fundamentally vulnerable). If you think about it, this makes much more sense than just purchasing things and thinking that they will go up.