How to Make Money Selling Short

Short selling is a technique that offers an investor the opportunity to make money by a stock he does not own. The investor borrows the stock from another investor and sells it hoping that the market price of the stock will decline. If the market price declines, the short seller buys the stock back at a lower price and returns it to the lender. For example, if an investor believes that a stock is overvalued at $30 and it is going to decline, he may borrow the stock from another investor and sell it for $30. If the stock declines to $25, the investor buys back the stock, returns it to the lender and realizes a profit of $5 per share. Similarly, if the price increases to $35, the investor realizes a loss of $5 per share. All the process is being executed through a brokerage firm.

Short selling bears an amplified risk because a stock's price may keep rising for quite sometime. This means that short sellers may theoretically lose an infinite amount of money. Instead, when an investor goes long (buys a stock) he may lose only the amount of invested money. For example, if he has bought a stock for $30 and the price declines, the maximum loss is $30, while if he goes short (sells the stock) and the price rises to $65 before he exits his position, then he realizes a loss of $35, which it's even more the stock's original price. This is the reason that short selling is mostly favored by sophisticated investors and advanced traders and not by average investors.

Short selling works efficiently in a declining or a neutral market, but there is no guarantee that the stock price will decrease as hoped or expected. Market is driven by numerous factors including the behavioral aspects of investors and therefore the direction of the market cannot be accurately predicted at any given time.

To make money with short selling investors use stock picking methodologies, insider trading and fundamental analysis. A very important indicator for applying short selling is short interest, which reveals how many shares have already been sold short. If the number of short stocks is high, then it is dangerous to take a new short position.

Another method to anticipate possible losses from short selling is to trigger protective stop orders. Stop orders are applied when overvalued stocks of companies with poor fundamentals endure suddenly a gap-up and they spread fear in the market, particularly to investors, who hold short positions on these stocks. Investors should be disciplined and adhere to their plan.

Conclusively, short selling is a complex strategy, which does not guarantee profit. Investors should be ready to accept that they may incur losses, but they also need to know how these losses can be reduced to the minimum level.