By Brigitte Yuille

Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let's take a look at how this transaction would unfold.

Step 1
: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.


Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says "short sale" and "buy to cover." In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:
  • the brokerage firm's own inventory
  • the margin account of one of the firm's clients
  • another brokerage firm
You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan. (To learn more, read the Margin Trading tutorial.)

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

One of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $2,500


The Stock Price Rises (stock goes to $90)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $90 -$9,000
Your Profit -$2,500

Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you expect it to (just as with buying long).

Shorter sellers use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven't been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn. (For more insight, read Short Interest: What It Tells Us.)


Next: Short Selling: The Risks »


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