When you short a stock you are placing your investment dollars on the line saying that you believe that the particular stock (or other form of investment) will decrease in value over a specific period of time. Shorting a stock can be thought of as the exact opposite of purchasing a stock. When you purchase the stock you are saying that you believe in the company. When you short a stock, you are doing exactly opposite.

To short a stock, you need a margin account with your broker. Then just place an order like you normally would, but instead of “buy” use “Short”. What this does is, it borrows shares of your chosen company from your broker and sells it in the market. You receive proceeds from that sale, but since that stock did not belong to you, you have to give it back to your broker at a specified later date. You will make profit if the price of the stock goes down and lose money if it goes up because you will have to buy back that stock from the market at some point in the future. Since you have already pocketed the money from the sale of the stock, now you need to pay to purchase the stock and give it back.

I know, all this sounds strange buy let me give you an example. Say, I shorted 100 shares of a company called ABC for $10.  Then rather than paying, I would receive the proceeds of $1000 minus the commissions. Now, I will have to close this short position by purchasing the stock. This action is known as “cover”. If the stock price of ABC drops to $9, then I make profit. I only have to spend 100 * $9 = $900 plus commissions to buy back or cover this stock. My profit is $1000-$900 = $100 minus the commissions.

To cover a position, you place an order like you normally would, but instead of “Sell” use “Cover”.

If you are unsure of where to start when picking something to short, then you should start listening to the stock tips or stock picks that you get from email newsletters or other sketchy sources. Many times those who are inexperienced in the market are the ones most willing to give out stock tips. They may be giving you information on the latest hot stock, but often times these “hot tips” turn out to be nothing more than an over hyped company or a pump and dump technique.

When you hear about a stock that seems to be too good to be true, then you may have an excellent opportunity. Start researching the company and see what you can find out about their core business. If something seems a bit fishy, then start placing your money on the short side so that you can profit from the drop in price.

Remember, shorting stock is extremely dangerous as there is no limit to how much you can lose. You may lose more than your principal. Always invest with caution.

Check out the margin rates of two of my favorite discount stock brokers:

Margin Rate Comparison between Zecco and TradeKing

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