Short stock or shorting stock occurs when traders or investors first sell stock they do not own and then buy it back at a different price. You might run for the nearest exit after hearing that definition of what shorting stock is all about, but try considering this from a different perspective. The market does not always go up, and it is not uncommon to see a stock price plummet downward at a rate much faster than its upward ascent. Wouldn’t it be nice to be able to make money when a stock goes down in price?
How Shorting Stock Works
Can the average investor short stock? In most cases, the answer is yes. It is important and necessary that the brokerage account that you use is a margin account. A margin account will allow you to borrow money for the purchase of stocks. Shorting stock is considered a risky venture in the eyes of a broker. Why? If you buy a stock and it falls flat, the worst that can happen is that it will go to zero, and you will lose your entire investment. However, when you short a stock, you will lose money if the price goes up.
As an example, if you buy 100 shares of stock at $10 it could fall to zero, and you would lose 100 shares times $10 per share for a total loss of $1,000. Ouch! On the other hand, if you decide to short that same stock and sell 100 shares at $10 and the stock falls to zero, you have just made another $1,000. Unfortunately, this same stock could potentially rise to $50 per share, or $100 per share, or $1,000 per share. At the unlikely extreme of $1,000 per share, you would lose $100,000. This is an extreme example just to illustrate what could potentially go wrong. Remember, you want the stock price go lower when you short a stock.
When Is It Beneficial
Shorting a stock can be beneficial if you manage your own portfolio of stocks and you happen to have a very strong feeling that a particular stock will fall in price very soon. Shorting stock can be particularly handy if the entire market or a particular sector suddenly starts to correct and moves downward. Or, maybe you have been following a single stock and know when things are not looking right. Shorting this stock is an option for you if a drop in price is expected.
Shorting stock is just another tool that allows you to play the market both ways. Just remember that trying to make money when a stock goes down is a double-edged sword. It is very possible that the stock you expect to go down suddenly reverses course, and you are now on the wrong side of the trade.