Short Selling Stocks: Taking Advantage of Downturns

The stock market can be a great place to save money. Because of inflation, money kept in a jar or under a mattress actually loses value over time. That is, $100 in 200 only buys as much as $78.40 in 2010. In order to combat this effect, money must be kept in such a way that it appreciates at faster than the rate of inflation. So, if the rate of inflation is 3%, money must accrue interest at at least 3% to maintain value.

The stock market has generally appreciated at about 10% over its history. Of course there are many exceptions, the recession of the 2000s being the most notable in recent history. Also, the stock market and individual stocks are not the same thing. While the stock market has risen an average of 10% a year for the past several decades, individual companies sometimes do much better than that, but might also die completely, rendering the shares of their stock completely worthless.

Taking Advantage of Volatility

Because of the very real possibility that the stock market will not rise at the rate of inflation over the short-term, and because short-term can be anything less than a couple decades, some investors eschew this strategy in favor of one that capitalizes on another of the stock market’s trends: volatility.

Short-term strategies take advantage of the fact that while the stock market tends to rise continuously over a half-century or so, it also tends to experience up-and-down swings over a weekly, daily and hourly basis. Selling high and buying low is a great way to capitalize this. Often an investor will make several purchases per day, and several sales per day. With this strategy, money is made by selling the stock at a higher price than it was purchased, but if the stocks one is tracking all lose value throughout that day, the time was lost.

Short selling is a way to capitalize on the volatility of the market, while not wasting time if the market falls. Basically, the strategy is the same: buy low; sell high. But the difference is that in contrast to regular stock trading (or commerce of any other sort) which requires the investor to purchase the goods before selling them, short selling allows for selling before buying.

Sell Before Buying

How can one possibly sell a stock before buying it? Does that mean you sell a stock you don’t currently own? In a word, yes. Imagine that you wanted to do this with cars. For the example to work with cars, imagine that every car of a given make, model and year were the same as every other car of that make, model and year. So, for our short-selling-cars analogy, go to a car rental place and rent a car for an extended period of time. Then, sell the car to a third party. After that person drives the car for a while, the car will depreciate. Buy the car back from the third party and return it to the rental agency.

While this example won’t work in real life because the rental fees will almost certainly be much higher than the amount you make from buying and selling the car. Also, when you rent a car, you don’t get the title, so you can’t legally sell it. But, it illustrates how short selling works. Sell a stock short, wait for it to go down in price, and then buy to cover at a lower price, profit.

The danger that exists with short selling stocks is that while cars decrease in value at a fairly steady rate, stocks might rise or fall. When selling short, the potential for loss is technically unlimited. Monitor the potential for stock gains and be sure to cut losses if the price rises above your threshold.