Shorting a Stock--Going Short: What does this mean?

What does it mean to "short a stock?" (This is also called "going short" or "selling short.")

I will explain this by starting from the other direction and comparing "shorting a stock" to it.

When you BUY a stock, you give MONEY in exchange for some stock. You buy the stock, hoping that the value (price) will increase after you buy it.

There are two (2) major objectives of BUYING a stock.

1. Profit Chunk: You buy the stock at a low price. Then you resell the stock for a higher price. The difference between the selling and buying prices is your profit--one and done until you do it again.
   
2. Passive Income: You buy the stock with the intention of holding onto it so that you can collect money from dividends (or call options). It generates income for you without you having to work for it.

This is, sometimes, "going long." (opposed to "going short")

You can also do the exact opposite. Some of you might be thinking "sell" is the opposite of buy, but it's even more extreme.

Since buying a stock is exchanging MONEY in return for STOCK, the opposite is...

SELLING STOCK in exchange for MONEY. Yup! You read that right.

How does that work?

You sell stock (that you do NOT have) in exchange for getting back money. Later, you give money to "buy back" the stock that you sold.

Why would you do this?

Well...This works VERY nicely when you SELL the stock at a HIGH price and BUY back the stock at a LOW price.

Shorting a Stock: Example

• You sell 100 shares of XYZ stock for $15/share. (This puts 100 Shares * $15/Share = $1500 into your account, but you owe 100 shares of XYZ stock.)
• Later, you buy back those 100 shares of XYZ stock for $8/share. (This means you have to pay 100 Shares * $8/Share = $800.)
• Your Profit = $1500 to Sell - $800 to Buy = $700 Profit
  

Wow! That sounds great. Why doesn't everyone do it?

First, not everyone knows about it or understands what it means to short a stock.

Second, I will cover the pros and cons of buying and selling, but there is also something else that is important. Not everyone has enough money available to be allowed to do that.

What does having enough money have to do with "selling" stock? They just GIVE me money, don't they?

You need to have enough available money in your brokerage account to be able to cover the cost if you lose.

Since you're borrowing stock (by selling it when you don't really have it), the brokerage firm "lending you the money" wants to make sure that you are capable of "repaying" back that money--plus more--if the stock price rises. (This means that YOU are losing money.)

What if I NEVER buy back the stock? I'd never have to pay, right?

That's another thing. The brokerage firm that let you borrow the stock can call back that stock. They will do this if they feel like the stock value has increased too much. (Another words, THEY want their money.)

If this happens, then you have to pay to buy back this stock. If you do not have enough cash, this can force you to sell another stock or bond more quickly than you want.

What are the benefits of Shorting a Stock?

Mostly, this provides people a way to make money when the market (or at least the stock) is trending downward. Most people only know how to make money when the market is trending upward. Shorting provides an alternative for investing in a down market.

You can also make "free" money since you can invest in other things that are going upward without having to sell that stock. It's sort of a way to invest in two places at one time.

What are the downsides to Shorting a Stock?

You need to have enough money to be allowed to short a stock.

The biggest downside is that there is NO LIMIT as to how much you can lose. There is a cap on how much you can make since the stock price will NEVER go below $0. However, theoretically, the stock price can rise to infinity. You'd have to buy back that stock at a really high price. That could be a huge disaster.

Shorting a stock, or going short, can be a great way to make money, but you have to be really careful.

Disclaimer: This author has never shorted a stock.