There's a way to make money on falling stocks. It's called going short or short selling. But before you put in your order, you need to know exactly what you're doing and the consequences. One of them: you can lose an infinite amount of money when you short a stock. Maybe reading further is a good idea.
We've all had stocks that have dropped dramatically in a day or two or week, sometimes 50% or more. What took months or years to achieve is lost in a matter of hours. Wouldn't it be nice if you could make money that fast, or at least make money from stocks when they go down? You can if you short a stock and understand the total concept.
First, shorting a stock means you sell something you don't own. The process is simple: you put in an order to Sell Short a stock, and your broker executes the order, if the stock can be shorted. Sometimes certain stocks aren't allowed to be shorted but that's another column. Let's deal with the ones that can. Facebook (FB) can't be shorted by most individuals yet.
Your broker sells a stock to a buyer when you send in the Short Sell order. The broker has to deliver that stock you don't own to the new buyer. So your broker borrows the stock from another account or another broker to accomodate you. Once your order is complete, you are hoping the stock goes down because you ultimately have to buy the stock back to close out your sale. Just as you sell a stock you own to get your money, a short sale requires that you do the opposite transaction to get your money, in this case, buy the stock back.
Fairly simple so far. But here's what happens when you short a stock:
-you have to pay the dividend, if there is one, on the stock.
-you have to pay interest on the amount of money you've borrowed to sell the stock, even though your account balance will show a positive number. Remember, you've sold something so you get the cash. Because a short sale is done only in a margin account, there are margin requirements and interest to pay.
-there is no limit to the amount of money you can lose. A stock you buy can only go to zero, and you lose the amount you invest. With a stock you short, there is no limit to the losses you take because it can go up forever. As it goes higher, you have to maintain a certain margin level, meaning you have to keep feeding your margin account with new money or other stock.
-you pay short term gains on a short position, no matter how long you hold it.
Shorting stock sounds easy. But it can be tricky and you need to know all the details before you take on this trade. It's mostly done by professionals and not recommended for the majority of investors. If you feel you would like to short a stock, consider buying a put option instead. It allows you to benefit when a stock goes down but limits your potential loss to the amount of money you pay for the put. Options, however, have their own sets of problems as well as opportunities. Don't work in that arena either until you fully understand them.
When stocks go down, it's tempting to try to benefit from that movement. But it's a very dangerous part of the investing world, one practiced only by investors who fully understand the consequences of going Short. And those investors know it's not easy money.
- Ted Allrich
May 29, 2012