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?
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.