Cashing in When Stocks Fall: How to Sell Stock Short - dummies

Cashing in When Stocks Fall: How to Sell Stock Short

By Matt Krantz

A class of investors, called shorts, look for opportunities to take advantage of falling stocks. They search the Internet for news stories about diners getting food poisoning at a restaurant, for instance, and look for ways to cash in on the stock falling.

Most investors are pretty optimistic folks. When they go to a restaurant, see long lines, and enjoy the food, they rush home to buy stock in the company that owns the restaurant. These types of investors, who hope to profit from a company’s good times and rising profits, are called longs.

Investors looking to short a stock do it through four steps:

  1. They borrow the stock they want to bet against.

    Short sellers contact their brokers to find shares of the stock they think will go down and they request to borrow the shares. The broker then locates another investor who owns the shares and borrows them with a promise to return the shares at a prearranged later date. The shares are then given to the short seller. Don’t think you’re getting to borrow the shares for nothing, though. You’ll have to pay fees or interest to the broker for the privilege.

  2. They immediately sell the shares they’ve borrowed.

    The short sellers then pocket the cash from the sale.

  3. They wait for the stock to fall and then buy the shares back at the new, lower price.

  4. They return the shares to the brokerage they borrowed them from and pocket the difference.

Here’s an example: Shares of ABC Company are trading for $40 a share, which you think is way too high. You contact your broker, who finds 100 shares from another investor and lets you borrow them. You sell the shares and pocket $4,000. Two weeks later, the company reports its CEO has been stealing money and the stock falls to $25 a share. You buy 100 shares of ABC Company for $2,500, give the shares back to the brokerage you borrowed them from, and pocket a $1,500 profit.

When you short a stock, you need to be aware of some extra costs. Most brokerages, for instance, charge fees or interest to borrow the stock. Also, if the company pays a dividend between the time you borrowed the stock and when you returned it, you must pay the dividend out of your pocket. You’re responsible for the dividend payment, even if you already sold the stock and didn’t receive it.