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In their effort to capture all the profit they can, many investors focus exclusively on buying stocks. That's too bad because it means they're missing out on half the profits – literally.

I say that because the markets move in two directions – up and down – which means there's plenty of profits to be had in both directions.

George Soros, for example, made a cool $1 billion in a single trade that famously almost broke The Bank of England in 1992.

John Paulson made billions off the housing crisis when it hit by going against the grain.

Doug Kass of Seabreeze Partners is known for betting against the herd and laughing all the way to the bank.

Obviously, shorting stocks isn't for everybody – it takes a lot of guts and more than a little conviction to do it profitably. Not to mention a healthy dose of discipline.

But done right, it can really boost your profits…

How to Short a Stock

You have to have brokerage approval and an appropriate amount of collateral on hand to do it. That's because, technically speaking, you're "borrowing shares" to sell them before you actually own them.

When you buy a stock, you are laying out cash at a specific price and hoping to sell it later for a higher price. You believe the price of that stock is going to rise.

When you short a stock, you are doing the exact opposite. You believe the price is going to decline so you sell it first and then buy it back at a later date and presumably at a cheaper price. Cash proceeds from selling are transferred into your account immediately.

When you want to exit a short trade, you have to "cover" the trade, meaning you have to buy those same shares at the prevailing market price and replace the ones you've borrowed from your broker.

The difference between what you received when you sold and what you paid when you exited is your profit. Of course, if the stock actually rises in price, the difference is your loss because it will cost you more to buy the same shares you've already sold.

Clear as mud? Here's a simple example that may help.

Let's say George thinks XYZ is doomed, so he checks with his broker to see if those shares are available for shorting – meaning the broker has them in "inventory."

The answer is yes, so George sells 100 shares of XYZ stock short at $100. He collects $10,000 in proceeds for his troubles. That money is deposited directly in his brokerage account.

A few months later, the price of XYZ has indeed fallen by 75% all the way to $25.

George decides he's not going to be greedy so he elects to buy the shares back or "cover" the trade, as it is known in trader-speak. So he takes the $10,000 he received when he sold and spends $2,500 of it to buy back the shares and return them to his broker.

The $7,500 difference between what he received and what he used to buy his way out of the trade is his profit in this example, excluding transaction costs that I haven't included here for simplicity's sake.

Obviously the reverse is true, too. Had XYZ's price risen above $100, George would need more money to buy shares back, so the trade would have been a loss had he exited at that point.

My Favorite Stocks to Short Now

So how do you find the best "short" candidates?

Join the conversation. Click here to jump to comments…

About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Gizwaldo | January 24, 2014

    Thank you so much for the simplified explanation, it is exactly what I needed.

    I like the your Facebook recommendation as I believe this is going to go down too, mainly due to the fact that people are now in fear of posting their true thoughts without fear of reprisal from the authorities. There's been too many publicised prosecutions for it to not have any effect.
    Plus the fact too that the newspapers only 3 days ago here in the UK published an article on the increasing numbers of people leaving FB for other social media platforms.
    Funnily enough the article was down playing this as if it did not mean anything and was in no way going to affect the future of the business…
    Many thanks!

  2. H. Craig Bradley | January 24, 2014

    Keith:

    I agree that Facebook looks quite overbought. Of course, I felt that way when it IPO'd back in May 2012 at $38.00/share. However, FB does seem to be emblematic of the FED's liquidity-driven stock market we have had since 2009. Facebook may be a sentiment indicator if nothing else.

    My question is: Why short it if you own some? Instead, what price do you sell at? The obvious would be if it were to end up at $90.0/share then there would be no question about it. I remember your stat that "85% of all stock transactions are not well timed". So, in a way, its like trying to determine the right valuation for buying or selling gold. Gold is driven by public sentiment at the margin ( panic or complacency).

  3. H. Craig Bradley | January 24, 2014

    IS IT REALLY A "STOCK PICKER'S MARKET"?

    Since excess FED liquidity has pumped-up so many stocks, if Facebook goes way down so might much of the stock market, as well. It may indicate that liquidity is being withdrawn from the system somewhere and "letting the air out" of momentum stocks like Facebook and Twitter.

  4. Keith Fitz-Gerald | January 24, 2014

    Thanks for your time guys and, as always for being part of the Money Morning Family.

    Gizwaldo, you're welcome – thank you for the kind words. Your point is exceptionally well taken. The mainstream press has an almost pathological rejection of anything negative when it comes to Facebook. To me that's yet more evidence that something's awry. If everybody is asking the same questions, then perhaps the questions are wrong.

    Craig, excellent points and thank you, too, for the kind words. Your points are very well made, but especially with regard to the liquidity. I expect there to be a general deflation as air is let out but I expect that to be compounded with stocks like FB and Twitter, in particular. That's because the lack of a path to profits isn't clear so the exodus may be farther and faster. No institutional investor will want to be left holding the bag.

    Speaking of which, I would advise any investor who owns Facebook or a stock like it to tighten up their trailing stops. I wouldn't worry so much about absolute prices as I would a fall from peak. We've used 25% as a standard suggestion but under the circumstances, I could make the case for something as tight as 10% given present trading action. Obviously every investor is different so what I am saying is generalized commentary for thought, not to be construed as individual investment advice in any way, shape, or form.

    Thanks again for being part of the family,

    Keith :-)

    • Tactical111 | January 25, 2014

      I use trailing stops just below the lowest low of the last three days including "today" after the close. Seems like a good way to ride a stock up for max profits and not get stopped out unless the swing is really wild. Works best on "deliberately" trading stocks with relatively low volatility.

    • Joseph Pedalino | February 5, 2014

      Hi Keith, I have been buying VXX for a hedge for the down market. But it has so many swings up & down even in the same day. is there a way to play this without getting caught in a rip saw. is it a buy and hold or do you play it day by day buying and selling. what is the best way to use this as a hedge.
      Thank You, Joseph Pedalino

  5. 000064458713 | January 24, 2014

    Interestingly, two researchers from Princeton's department of Mechanical and Aerospace Engineering don't understand the difference between correlation and causation. Their entire study is based on web searches. Did they ever stop to think about society's shift to mobile?

    Skewed model, skewed conclusions.

    Keith, I am going to have to respectfully and wholeheartedly disagree with you on this one.

  6. kenezen | January 25, 2014

    Great Article which I endorse completely. My one question is why not Short Futures? If one understands the global markets (Necessary as a fundamentalist) or has some magic as a technician then shorting the financial futures market seems a better way to gain profits from broad movements with some leverage?

  7. H. Craig Bradley | January 25, 2014

    -8713:

    You may disagree, but remember that logic is missing from these very speculative momentum stocks. FB declined about 2X that of the broader market indexes on Friday. So, we know whatever action the overall market takes will be magnified with social media companies who are not battle tested but relatively untested newbies. The Princeton engineering study is a bit "out of the box" for an engineer by the math is not. That's what engineers do, lots of applied calculations.

    Its interesting that their study "happened" to come out at the same time Facebook had a recent all time high too. Good marketing. For FB to recover, this correction will have to be over next week. If it persists, FB will go down. Keith is smart and prefers to take his gains while he can and not depend on the "kindness of markets" ( they are agnostic ). FB has gone up and down 20% before, so right now its a judgement call. My feeling is its a guess. If it goes back to 50 next week, it might be time to sell.

    For those who think we could end up in 1929 all over again, remember the first shot at the collapse was in Sept. 1929. The market fully recovered and then it went down again, and kept going down. The dam had burst. There is a chance FB and the overall market could recover if the FED plays it in the right way next week and confidence is restored. However, I would not expect a third chance. Next time sell for sure if you hold for now.

  8. H. Craig Bradley | January 28, 2014

    PROFITABLE, BUT NO FUN TO WATCH SLOW-MOE DECLINE

    Apple @ $1,000/ share is NOT going to happen before the next recession. Remember, Apple at its all-time peak of $701.0/Share only stayed at that level for about 10 days, then the fall-off began and snowballed. Such expectations are a left-over or relic from the last Bull Market for Apple (2010-2012) and the general investor mania that accompanied stocks in general. Like the Bullfights, the bull in the ring takes a long time to die at the hands of a skilled matador. He can draw it out and please the crowd (traders).

  9. H. Craig Bradley | January 29, 2014

    LUCK AND LIQUIDITY

    Well Keith,

    Facebook (FB) released their quarterly earnings. The numbers are up and so is the stock- after hours, of course, and by almost + 10%. I don't know what the Beta is for a (momentum) stock like Facebook, but it must be about 2-3 . No doubt there will be some selling tomorrow morning, but still, we both now have egg all over our faces. Clearly, neither of us really understand what Facebook is about or what is going on with it. We don't "get it". (uncool)

    Is it shrewd management by Zuckerman, or conversely, the result of too much luck and liquidity, as well as too much exuberance on the part of the investing public? Personally, I don't believe the numbers were all that good, so the after hours spike must be more sentiment- based. Clearly, the FED has a lot of liquidity to mop-up going forward and therefore, this is still a BULL market in 2014. No meaningful correction in the NASDAQ, at least so far. Is it 1998 all over again. Time will tell.

  10. H. Craig Bradley | January 31, 2014

    CLICKS & SNAPS

    For further evidence of a "bubble" just look at Snapchat, a mystical high flying start-up company ( no revenue or earnings). In 2012, Facebook offered $1 Billion, but was turned down. Last year, Zuckerman upped the ante to $ 3 Billion but again was rebuffed. Still no earnings or revenue.

    Now, does this recent price inflation history indicate there is first, $ trillions of liquidity still out there to fuel any kind of mania and secondly, a high probability of a "bubble" when a company can attract billions 'on the come', even with no earnings or revenue? It should not be a debate. We indeed have a bubble and when it pops, well the market could turn unexpectedly and quickly giving investors no time to run for cover or protect themselves. Another words, this all could be one big set-up, followed by a big knock-down.

  11. Roy Hagen | February 1, 2014

    Give me a week.

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