Should You Short Stocks?

By: ispeculatornew
Date posted: 04.13.2008 (8:05 pm) | Write a Comment  (7 Comments)

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If you are an experienced investor shorting stocks should be part of your investment strategy. Shorting allows you to profit when a stock goes down in price. In a declining market, such as the current one, it is a lot easier to make money shorting stocks than buying stocks.

When you short a stock you are actually borrowing shares of a stock from your broker and selling the shares. You owe the shares you sold (shorted) to your broker so you have to buy them back and repay them (cover) at some point. If you are able to repay them (cover) at a lower price than you sold them (shorted) you make money. If you buy (cover) the shares at a higher price than you sold (shorted) the shares you lose money.

I tried to explain that as clearly as I could but I will also use a rough analogy that I have read elsewhere to help explain what shorting is. Let’s say your friend has a bike that is worth one hundred dollars. You know that the same bike is going to be on sale the next week for eighty dollars. Therefore, you decide to borrow the bike from your friend and sell the bike for one hundred dollars (you just shorted the bike). The next week, when the bike goes on sale, you buy the bike for eighty dollars and give it back to your friend (you just covered the bike). You make twenty dollars. That is roughly how shorting works.

So is it a good idea to short stocks? This depends on how knowledgeable you are about a stock and how confident you are in your decision. The reason for this is you can lose more than one hundred percent of your investment when you short a stock. If you buy a stock and the stock price goes to zero you lose 100% of your investment. However, the stock price can’t go any lower. If you short a stock you may lose more than 100% of your investment because there is no limit to how high a stock can go up.

This scares a lot of people away from shorting stocks but it shouldn’t be a deterrent if you are an experienced investor who is confident in his/her stock decisions. However, if the idea of shorting makes you uncomfortable you probably shouldn’t short stocks. The reason for this is you need to have conviction in your investment decisions whether you are shorting or buying stocks. If you are not confident in what you are doing you are going to be more inclined to sell when your investments start to lose money. Since it is inevitable that some of your investments are going to go lower than the price you purchased at or go higher than the price you shorted at, you need to have confidence in your decision. If you are not confident in your investment decisions you will continually get scared into selling at a loss.

If you have never shorted stocks before it would be wise to paper trade before you short stocks with your actual money. I would recommend that you join UpDown if you want to paper trade because you can earn real money investing with play money, risk free.

Tomorrow I will provide some tips on how to make profitable short investments.

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7 Comments

  1. Comment by Eve — April 14, 2008 @ 1:15 pm

    Thank you Phillip, it’s real clear explanation. And thank you for the link, I will look it up.

    I bought CAAS at $5.8, holding on.

    I am losing big time in TMA, bought at $1.57, hope the patience pays off.

  2. Comment by Eve — April 14, 2008 @ 1:36 pm

    I just signed up updown.com through your link.

    I wish I can see the portfolios of the winners!

    Thank you.

  3. Comment by admin — April 14, 2008 @ 7:59 pm

    Hello Eve,

    I would be patient with CAAS. CAAS’s financial numbers will improve in the future and the stock price will reflect the improvement at some point. Updown doesn’t show the porfolios of the winners but you can send the top investors a message through UpDown to see what they are buying. A few weeks ago I sent a message to the person with the highest return to see what she was trading and she responded pretty quick.

    Phillip

  4. Comment by Eve — April 15, 2008 @ 5:47 am

    Thank you for the tip, Phillip

  5. Comment by Joe — April 15, 2008 @ 5:56 am

    Hi Phillip,
    I am not sure how shorting works in actuality. Like, I am a small time investor and I invest through sharebuilder. There I have option trading which I have subscribes to, but its hard to understand the “call option” and stuff like that. Can you tell us how exactly the “shorting” thing works with those online brokers such as “sharebuilder”?

    Thanks
    A Joe

  6. Comment by admin — April 15, 2008 @ 10:18 pm

    Hello Joe,

    I just wrote a post about how to short a stock through a broker. Options are quite a bit more complicated that simply buying or shorting stocks so I would avoid call options and put options if you are not familiar with them. If you are trying to enter a short order you would choose “Sell Short”. When you want to cover your short postion you would choose “Buy to Cover”. I provide more detail in the post.

    Phillip

  7. […] couple of months ago I wrote a couple of posts about what shorting is and how to place a short order. Now I will give you some general tips on how to make profitable […]

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