Money Tips: Shorting A Stock

The market is often the business of buying low and selling high. Short stocks follows the opposite trend. Advice on using this technique for profit.

When you short stocks you gain profit not when they rise, rather, when they fall. The concept seems confusing, and is contrary to what most people talk about when they refer to successful moves on the investment chessboard. However, shorting stocks is a proven way of making a bundle of cash, that is, if you know how to do it right. Here is the basic idea behind shorting a stock.

Before you short a stock you need to set up a margin account. A margin account allows you to buy shares of stock with money you do not have. With a margin account you set up a balance with your broker. After your initial deposit your broker may lend you additional amounts of money as you wish. Therefore, you can buy twice as many stocks of General Electric as your bank account would let you. This sounds great, however, at any time the margin can be "Ëścalled', that is, when the value of the collateral you put up for the loan falls below a predetermined minimum requirement. Usually that requirement is around thirty percent. If your margin is called or your borrowed stock is not performing well then you may find yourself needing to add additional funds to your balance to cover your losses. This is why the margin account is not to be used unless you understand, completely, the potential risks involved in investing borrowed money.

Ok, so you have your margin account and you are aware of the dangers involved. Now you want to short a stock. How do you do it? Basically shorting a stock involves the borrowing of shares from a current shareholder then, almost simultaneously, selling these borrowed shares at the current market price. Then, in the next few days you wait for the stock to plummet and sell. So let's take this step by step. First of all, you need to buy some stocks that you can't afford. Say you borrow 100 shares of Travelzoo stock from a shareholder (you actually do not have to do anything except tell your broker that you want to do this and he performs the task for you). After buying the stock you tell your broker to sell Tzoo at the current price, $95 a share. In the next few days, as you expected, the stock spirals down to $89 a share due to an outside factor you predicted or just got lucky on. At this point you tell your broker to buy back one hundred shares of Travelzoo at $89 a share. This enables your broker to return the newly purchased shares to the lender.

Sounds like a great way to make money, right? Shorting stocks can be a wonderful tool for savvy investors who like to make money off of other people's assets; however, shorting stocks can be very dangerous and may lead to financial woes if done improperly. Here is an example of how things can go very wrong with a short.

You've recently gone to CVS to purchases a quart of milk from the handy refrigerator conveniently located at the side of store and you had an awful experience""the purchasing lines were long, the staff was understaffed and unfriendly, and on top of that, the milk was sour. You are convinced this outfit is going south. So you decide to short CVS. You tell your broker to buy one hundred shares of CVS; he borrows one hundred shares at a price of $35 a share. He, upon your request, proceeds to sell these shares at the market value, $35 a share. Then you wait. You wait a few days and nothing happens. Apparently not everyone has had spoiled milk from the local CVS. In a week the stock actually increases. By next Thursday the stock has gone up three dollars and CVS has declared that it is taking over Eckerd, another pharmacy chain. Your plans for buying back shares to produce a profit were spoiled, just like your milk. At this point your broker advises it is best to cut your losses and to cash out. You then purchase the shares at $38 a share, a loss.

As with all investments, shorting involves a great risk. The risk is considered especially lethal because you are playing with money you, presumably do not have. Always do your research before you jump into the shorting game, and never base a financial decision on spoiled milk.

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