Short Selling

So far I have only told you ways to profit from the value of a stock increasing, buying low and selling high. Now I am going to introduce a way of making money when the value of a stock is falling, called short selling.

If you execute a short sale of 100 shares of Google (Nasdaq: GOOG), you effectively borrow 100 shares from your broker with the promise to return the shares at a later date with interest on the current value of the stock. You then immediately sell those 100 shares. Then once the stock has dropped in value you can repurchase the 100 shares from the market and return them to your broker with the interest you owe. It is important to note here that when repurchasing the shares from the market, you have to specify "Buy to Cover" in the order type.

You make profit according the original price of the stock(P1) minus the current price of the stock(P2) minus the interest rate(i) times the length of time you borrowed the shares(t) times the original price of the shares all times the number of shares you borrowed(S#).

S#(P1 - P2 - itP1)

So if you short sold 100 shares of Google at $600/share at an interest rate of 4%/year and repurchased the shares 6 months later at $500 you would profit:

100($600 - $500 - .04 x .5 x $600) = $8,800

Considering this required an investment of only $1,200 in interest, you would have made 633% on your money, because if you will remember, you only borrowed the initial shares.

Be careful though because if you predict the market wrong you can lose a lot of money. If we describe that situation again but swap the initial and ending price, we can see how potentially devastating a short sale can be.

100($500 - $600 - .04 x .5 x $500) = -$11,000

Ouch.

Good luck profiting from failing businesses.