Frank looked up from his newspaper and sighed. It had not been a good week in the markets, and the short-term forecasts from the analysts were not very optimistic. Of course, if he wanted to profit from a market downturn, he could always buy put options on one of the market indexes, but he felt that option trading was not the answer. "I sure wish that I had stock to sell right now," he thought. "Then I could buy it back at a big discount in a month or so."

Of course, Frank can do exactly that by placing a short sale. Read on to learn more about short sales and how they can help you through market downturns.

What is a Short Sale?
By definition, a short sale is a transaction in which the seller does not actually own the stock that is being sold, but borrows it from the broker-dealer through which he or she is placing the sell order. The seller, of course, then has the obligation to buy back the stock at some point in the future. Short sales are margin transactions, and their equity reserve requirements are more stringent than for purchases.

Short sales are executed by investors who think the price of the stock being sold will decrease, usually in the short term (such as a few months). It is important to understand that short sales are considered risky because if the stock price rises instead of declines, then there is theoretically no limit to the investor's possible loss. As a result, most experienced short sellers will put a stop-loss buyback price on their orders, so that if the stock price begins to rise, the short sale will be automatically covered with only a small loss.

Advantages of the Short Sale
The main advantage of a short sale is that it allows investors to profit from a drop in the price. If a stock is selling for $70 a share and then a major company scandal is exposed, it is seemingly impossible to make money by purchasing shares at this point. The only sensible course of action is to borrow shares of the stock and sell them, while the price is high, and then buy them later after the price has dropped. Short sales, therefore, allow investors to buy low and sell high, albeit in reverse order. Furthermore, short sales allow for leveraged profits because these trades are always placed on margin, which means that the full amount of the trade does not have to be paid for. Therefore, the entire gain realized from a short sale can be much larger than the available equity in an investor's account would otherwise permit.

Disadvantages of the Short Sale
As stated earlier, one of the main drawbacks to short sales is the inherent risk involved. A short seller who has not covered his or her position with a stop-loss buyback order can suffer tremendous losses if the stock price does not decline.

For example, consider a company that becomes embroiled in scandal when its stock is trading at $70 per share. An investor sees an opportunity to make a quick profit and sells the stock short at $65. But then the company is able to quickly exonerate itself from the accusations by coming up with tangible proof to the contrary. The stock price quickly rises to $80 a share, leaving the investor with a loss of $15 per share for the moment. The price may recede to where it was before, but it's not likely the investor will see a profit in this scenario. And, of course, if an investor sees a disappointing earnings report on the horizon and shorts the company's stock beforehand and then the company unveils some new miracle product that sends the stock price heavenward, the investor had better have a stop-loss buyback order on the books, or he or she will have to eat the entire rise in the price of the stock.

There is another major obstacle that short sellers must also overcome. The markets have historically moved in an upward trend over time, which works against profiting from broad market declines in any long-term sense. Furthermore, the overall efficiency of the markets often (but not always) builds the effect of any kind of bad news about a company into its current price. If a company is going to have a bad earnings report, in most cases the price will have already dropped by the time the report actually comes to press. Therefore, in order to make a profit, most short sellers must be able to anticipate a drop in stock price before the market has had a chance to factor whatever is causing the decline into the price.

Many successful short-sellers profit by finding companies that are fundamentally misunderstood by the market (i.e. Enron and Worldcom). For example, a company that is not disclosing its current financial condition can be an ideal target for a short seller.

The Bottom Line
While short sales can be profitable under the right circumstances, they should be approached carefully by experienced investors who have done their homework on the company they are shorting. Both fundamental and technical analysis can be useful tools in determining when it is appropriate to sell short.

Related Articles
  1. Mutual Funds & ETFs

    The 3 Best Downside Protection Equity Mutual Funds

    Learn how it is possible to profit in a bear market by owning the correct selection of mutual funds that provide downside protection and opportunity.
  2. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  3. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  4. Investing News

    Market Outlook: No Bottom Until 2017?

    These investing pros are bearish on the market in 2016. Will there be a bottom in early 2017?
  5. Your Clients

    How Advisors Can Make the Most Out of Volatility

    Advisors can use market volatility as an opportunity to enhance their value to their clients and grow their practice. Here's how.
  6. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  7. Investing News

    With Short Interest Surging, Is it Time to Buy?

    What do you think the smart money is doing when the market moves higher? Apparently, they're building short positions.
  8. Term

    What is Pegging?

    Pegging refers to the practice of fixing one country's currency to that of another country. It also describes a practice in which investors avoid purchasing security shares underlying a put option.
  9. Economics

    Why Enron Collapsed

    Enron’s collapse is a classic example of greed gone wrong.
  10. Home & Auto

    Understanding Pre-Qualification Vs. Pre-Approval

    Contrary to popular belief, being pre-qualified for a mortgage doesn’t mean you’re pre-approved for a home loan.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. How does a forward contract differ from a call option? (AAPL)

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  6. How can I hedge my portfolio to protect from a decline in the food and beverage sector?

    The food and beverage sector exhibits greater volatility than the broader market and tends to suffer larger-than-average ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center