When the stock market drops, most people lose a lot of money.  You don’t have to be one of those people!

For those of you who don’t know what short selling is, it’s a trade you make when you believe that the price of a stock will drop.  Short sellers sell stock they don’t own and hope to buy those shares back at a lower price, thus making a profit. Here’s an example -

Bob thinks that stock XYZ, which is currently trading at $30.00, is headed lower.  To profit on this idea, Bob borrows 200 shares of XYZ from his broker and sells them.  In doing this Bob has borrowed 200 shares of a $30 stock, which is a total of $6,000 (200 x $30 = 6,000).

When XYZ falls to $25, Bob covers his short by buying 200 shares, which is a total of $5,000 (200 x $25).  Now Bob replaces the 200 shares he borrowed from his broker.  He gives them the same amount of shares back that he borrowed and he is able to profit $1,000 ($6,000 – $5,000= $1,000).

Here’s an example to illustrate short selling in everyday life -

Your friend Alan has 2 tickets to a Rolling Stones concert.  Alan bought the tickets for a total of $300.  Due to the weak economy, you think the price of the tickets will drop, so you tell him to lend you his tickets so you can make some money on them.  Being the good friend he is, he agrees but makes you promise that even if you are wrong and the tickets go up in value instead of down, at some point you must give him back the original tickets.  You take the tickets and sell them on craiglist.com for $300.

As the weeks go on, your idea proves to be right!  The price of the tickets has dropped dramatically. One day you see that the same tickets you sold for $300, is selling for $200.  You buy them for $200 and then return them to Alan.  You just profited $100 from “short-selling” Rolling Stones tickets ($300-$200 = $100).

Short selling isn’t as complicated as you think it is.  When you want to short sell a stock on your online broker’s website, select the stock, amount of shares you wish to trade, and where it asks you what action you would like to take, you select “short.”  It’s as simple as that.

Short selling is essential to being a successful active trader.  Don’t be intimidated by it.  I have talked to too many people that shy away from shorting because they don’t understand it.  Like I always say, don’t run away from things you don’t understand – instead, take the time to learn about what you don’t know.