The traditional view of making money in the stock market involves a thorough analysis of a company and shrewdly purchasing stock while it is at a low point in its cycle. Next, the stock is held for a period of time until the value has gone up, and then the shares are sold for a profit. While this may be the preferred (and most common) way for people to make money, there is another, less traveled road.
Another method used is known as shorting a stock AKA short
selling. It is not a common practice especially for newer investors, but it
is good to understand the concept. The first thing to understand is that you are
not the official ‘owner’ of the stock that you are shorting, but you have the
right to that stock at some future date at a pre-determined price.
The belief for someone shorting is that a particular stock will decrease in
price. That is, in other words, that the price per share will be lower than it
is today. I know this sounds confusing, but hopefully by the end of this
article, you will have a handle on it. You are telling your broker that you are
willing to buy the stock for a set price in the future. You then ‘borrow’ the
shares and they are sold. Your responsibility to pay for them lies in the
future.
This is more clearly explained by giving an example with some numbers thrown
in. Check this out and then return to the first couple paragraphs, and you
should have a pretty firm grasp.
You are short selling 100 shares of ABC Mills. Today’s price for ABC is $50.
You research has indicated that the price will drop to $40 per share. Fast
forward one year. ABC has dropped in price, but only to $45 per share. Because
the initial price for the transaction was $5,000 and your shorted price for
those shares is $4,500 you have made $500. You had contracted to buy those
shares in advance, at whatever price they demanded. In this case, your short
strategy worked out and you made some money. (Remember that brokerage fees still
apply to this type of trade, so the $500 doesn’t take into account commissions,
and certainly is pre-tax, as well – just a point to always keep in mind.) In the
event that you shorted the same stock, under the same situation, and the price
went up, you would end up paying the difference. So if the price actually rose
to $55 in the same time frame, you would owe $500 to the owner of record.
A different way of making money when a stock price falls is called a put.
This method is similar to a short, but a put gives the buyer the option to sell
the stock for a fee. The buyer is not obligated to sell the stock, but does have
the right to do it. Using the example above, if I would buy the PUT on those 100
shares, I would pay an agreed upon amount to the owner of the shares for the
right to sell them at a later date. For this example, say I paid the owner $2
per share for the put option 1 year out. The price moved from $50 to $45 in the
one year period. I could then choose to sell the stock at the $45 price and make
$500 (minus the put cost of $200.) If the price went up, instead of down, I
could decline my option, and I would lose the $200.