Traders often ask me if it is necessary to short stocks to be successful. My resounding answer is NO but you leave a lot of money on the table by just trading Long. After inquiring deeper I usually find that most traders just have a lack of understanding regarding how shorting stocks works than a philosophical or patriotic issue. So, here’s a quick overview of how it works.
A trader who sells a stock short borrows shares from a broker’s inventory and sells them to another buyer. Proceeds from the sale go into the trader’s account. The trader must buy those shares back (cover the position) at some point in time and return them to the broker.
Thus, if you sell short 1000 shares of IBM at $20 a share, your account gets credited with $20,000. If the stocks price subsequently declines, then you will start thinking about "covering" your short position for a profit. Here's the record of transactions if the stock falls to $8.
Borrowed and Sold Short 1000 shares at $20: +$20,000
Bought back and returned 1000 shares at $8: -$8,000
Profit: + $12,000
But what happens if the stock begins to takes off, from $14 to $19 to $26 and then to $37! You finally decide that you'd better swallow hard and close out the transaction so you buy back shares of IBM at $37.
Here's the record of transaction:
Borrowed and sold short 1000 shares at $20: +$20,000
Bought back and returned 1000 shares at $37: -$37,000
Ouch. So you see, in the second scenario, you lost $17,000…which you'll have to come up with. There's the danger….you have to be able to buy back the shares that you initially borrowed and sold. Whether the price is higher or lower, you're going to need to buy back the shares at some point in time.
I hope this was a helpful overview. To learn more about short selling, try reading the following books:
"Tools of the Bear: How Any Investor Can Make Money When Stocks Go Down" – Charles J. Caes;
"Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud" – Howard M. Shilit;
"When Stocks Crash Nicely: The Finer Art of Short Selling" – Kathry F. Staley;