Short-Selling in an Uncertain Economy
Short selling involves selling a stock you don’t actually own in order to profit from a decline in price. So when you short a stock, you want the value to drop.
When you short a stock, you borrow shares from your broker through a margin account and immediately sell them on the open market. The proceeds are then deposited into your account.
Eventually you repurchase the shares and return them to your broker to close out the short position. Your goal is to pay less to buy back the shares than you received from selling them. If you do, you get to keep the difference! Here’s an example:
XYZ stock is trading at $25 per share. You think the true value is around $15 per share. You decide to speculate that the price of XYZ will decline, so you sell short 100 shares of XYZ stock at $25 per share.
Your broker loans you 100 shares, you sell them on the open market, and the $2,500 in proceeds is deposited into your account. (100 shares x $25 per share = $2,500).
Two weeks later, XYZ stock declines to $19 per share. You purchase 100 shares to return to your broker at $19 per share.
Your profit from the transaction is $600. ($2,500 from the sale of XYZ – $1,900 to repurchase XYZ).
Keep in mind that this example doesn’t account for the commissions and fees that apply in the real world!
You don’t necessarily need to master short selling yourself to incorporate a short-selling strategy in your portfolio. Some mutual funds, called long-short funds, use short selling as a part of their active strategy. Walk carefully with these funds though. Make sure you understand and are comfortable with both the strategy and fees.