Making A Bundle By Going Short

Going short (also called shorting a stock, selling short, or doing a short sale) on a stock is a common technique for profiting from a stock price decline. Investors have made big profits during bear markets by going short. A short sale is a bet that a particular stock is going down. To go short you have to be deemed (by your broker) credit-worthy; your account needs to be approved for short selling. When you're approved for margin trading, you're probably set to sell short, too. Speak to your broker (or check for this information on the broker's Web site) about limitations in your account regarding going short.

Most people easily understand making money by going long. It boils down to "buy low and sell high." Piece of cake. Going short means making money by selling high and then buying low. Huh? Thinking in reverse is not a piece of cake. Although thinking of this stock adage in reverse may be challenging, the mechanics of going short are really simple. Consider an example that uses a fictitious company called DOA, Inc. As a stock, DOA ($50 per share) is looking pretty sickly. It has lots of debt and plummeting sales and earnings, and the news is out that DOA's industry will face hard times for the foreseeable future. This situation describes a stock that is an ideal candidate for shorting. The future may be bleak for DOA, but promising for savvy investors.

You must understand brokerage rules before you conduct short selling. The broker must approve you for it, and you must meet the minimum collateral requirement, which is typically $2,000 or 50 percent of the shorted stock's market value. If the stock generates dividends, those are paid to the owner of the stock, not to the person who is borrowing it to go short.

Say that you believe that DOA is the right stock to short - you're pretty sure its price is going to fall. With DOA at $50, you instruct your broker to "go short 100 shares on DOA." (It doesn't have to be 100 shares. This is just as an example.) Now, here's what happens next:

1. Your broker borrows 100 shares of DOA stock, either from his own inventory or from another client or broker. The broker guarantees the transaction, and the client/owner of the stock never has to be informed about it, because he never loses legal and beneficial right to the stock. You borrow 100 shares, and you'll return 100 shares when it's time to complete the transaction.

2. Your broker then sells the stock and gives you the money. Your account is credited with $5,000 (100 shares x $50) in cash - the money gained from selling the borrowed stock. This cash acts like a loan on which you're going to have to pay interest.

3. You use the $5,000 for a little while. Your broker has deposited the $5,000 in your account. You can use this money to buy other investments.

4. You buy the stock back and return it to its rightful owner. When it's time to close the transaction (either you want to close it, or the owner of the shares wants to sell them, so you have to give them back), you must return the number of shares you borrowed (in this case, it was 100 shares). If you buy back the 100 shares at $40 per share (remember that you shorted this particular stock because you were sure its price was going to fall) and these 100 shares are returned to their owner, you make a $1,000 profit. By selling short, you made money when the stock price fell!