I recently read a poll that found many US-based investors who had a stock portfolio of $100k or more had zero idea how to short a stock, or how shorting a stock would affect their portfolio, for that matter. So let's walk through a simple explanation of how to short a stock, and look at the related math.
Buying/Selling a Stock
We need to start with the simplicity of what happens when buying a stock in order to understand how to short a stock. So, in order to do that, let's look at IBM (IBM) :
Long (Buy) 100 Shares of IBM today @ 162 total value (not counting commission) = $16,200 value
Shares rally to $172, Sell 100 shares* of IBM = $17,200 value
Profit = $1,000*
Shorting a Stock
Now let's look at Shorting a Stock using the same scenario:
Short (Sell) 100 Shares of IBM today @ 162 total value (not counting commission) = $16,200 value
Shares fall to $152, Cover (Buy) 100 shares of IBM = $17,200 value
Profit = $1,000*
What to Know Before You Go Short
Without going into all of the confusing stuff, I suggest you contact your broker and experiment with shorting a stock, and watch the balances in your account move in relation to stocks you are long. I would also look at the commission, because it is different than buying stocks, and keep in mind none of the above examples use leverage – this is all fully paid for at the time of the trade. There is also no accounting here for commission or taxes. I also suggest you use the mock trading tools nearly all trading systems (Scottrade, etc.) provide, so you can watch how they move.
The second thing you need to know about shorting a stock is that in order to short it you must get a borrow. Much of this functionality will appear in whatever trading system you use or broker you call. They will tell you if the stock is "short-able," and you will need a "confirmed borrow" to enact a short sale. Many stocks are not short-able – you will find many sub-penny stocks where you cannot get a borrow, and many tight float stock are difficult to borrow, but the point is, you can make money when stocks go down.
If shorting was not a part of the stock market math, stock movements would be predictable. The beauty of our markets is that the ability to short stocks tosses a variable into the equation, making market movements less predictable.
*Before commission and taxes
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer