The stock market can be an intimidating place. Not just for beginners, but even for seasoned investors. And perhaps no activity in the market is surrounded by more mystery and confusion than short selling.
Short selling allows you to make money when a stock goes down, which instinctively sounds wrong. To some it even sounds illegal (like my mother). But rest assured (mom), short selling is 100% legal and by the time you are done reading this, you will have a full understanding of the practice.
The easiest way to explain short selling is to use a simple non-financial analogy.
Let’s say that your friend ordered a new, silver 16GB iPhone 6 Plus from Apple, and that the day it was delivered to his house you asked him to borrow it before he could even open it.
Now let’s say that you took your friend’s new iPhone and sold it for $600.00 — which could be a problem because if he finds out, he’ll probably punch you in the mouth. Rightfully so I might add.
But fisticuffs aside, what you have just done is sold an iPhone short.
You now need to return him one iPhone — and not just any iPhone, but a new, silver 16GB iPhone Plus — so you start looking around to find one.
The local big box retailer has them for sale for $649.00, but if you buy one there and return it to your friend, you’ll lose $49.00 on the transaction.
Instead, maybe you find someone on Craigslist who received two for their birthday and is willing to let one go for $550.00. So you buy it, return it to your friend, and pocket the difference between the $600.00 you sold it for and the $550.00 it cost to replace it.
In this scenario you have made a profit by shorting — selling something that doesn’t belong to you and replacing it at a later date, at a lower cost.
In the stock market it’s the exact same concept. You borrow shares of XYZ Company — just like the iPhone — and sell them. At some point you have to return those shares, and if you can buy them back for less than you sold them for, you make a profit. If not, you take a loss.
The only difference is that the venue for both buying and selling the stocks would be the stock market, and you borrow shares from, or via, your brokerage, not your buddy.
Brian Lund is a veteran trader with 30 years of market experience and VP of Business Partnerships at SparkFin.
The SparkFin app is a free and easy way to get new stock ideas every day. So do us a favor — download SparkFin from the iTunes store — and then go crush the market.
