Shorting Stocks? What Is A Short Sale?

I remember hearing investors talk about "shorting" a stock a few years ago, but I never understood what they were talking about.  Shortly thereafter, I was finishing up some finance classes in college when we came across the "short sale" topic.  I've had friends ask me about this a few times, so I figured I would put a very simple explanation of this on the blog.

In the simplest terms, short selling a stock is a bet against the stock.  If you believe that a stock is overpriced, and due to decline in value, then you would short the stock.  You are betting against the firm's stock price.  For example, let's assume you look at a stock with a price of $100/share.  You have a gut feeling that the firm is going to have a bad quarter, and you believe the stock is going to drop down to $70/share.  Well, in this case, you would not want to buy the stock at $100 if you believed that you would lose 30% in value, but you would want to "short" the stock.

What happens next is the interesting thing.  Let's say you commit to buying 1,000 shares that you believe will be selling for $70/share in the next month.  If the stock drops in value, great, you buy the 1,000 shares at the lower price and you profit from the difference.  But, if the stock goes up to $200, you are forced to purchase the 1,000 shares at the higher price.  See the risk involved?  There are certain protections you can look into when dealing with short selling stocks, but I will simply tell you to contact a financial representative for more details if you are a novice investor interested in short selling.

The reason you commit to buying the 1,000 shares, is due to the fact that you are temporarily borrowing the 1,000 shares at $100/share.  In essence, you start the process by borrowing the shares, collecting the 1,000 shares at $100/share (that calculates to be $100,000), then you later return these shares for the profit or loss.  If the stock goes down to your target price of $70/share, you then purchase these shares (at a cost of $70,000), return the 1,000 shares that you borrowed, and walk away with $30,000 in your pocket.  Simple right?

Buyer beware, if that stock prices goes up, you are stuck paying that difference.  With any investment, there is always a risk involved, so be cautious.

Last note:  Should investors, brokers, and firms be scrutinized for profiting off short sales?  Some people tend to believe that the entity betting against a firm must have known something ahead of time.  Examples:  "Why did you short the stock?  Did you know in advance that the mortgage-backed securities were worthless, so you bet against them?  Why didn't you warn the general public or SEC?  If you knew the firm was struggling, you should have told everyone!"

There are plenty of arguments to support and defend short sales, but I will leave the ethical discussion of short selling to your next cocktail party :-)