How to Make Money When Stocks Go Down (shorting explained)
Updated: Mar 7, 2021
Everybody understands how an investor makes money when stock prices are going up. All you have to do is buy the stock hold it and sell it to somebody else for a profit. A tougher question is how could an investor make money when the stock price is going down? The answer is short selling.
Short selling allows investors to bet that the price of a stock is going to go down and make money when it does. For example, if you go short a stock at $100 and cover at $90 you would make 10$ a share from the stock moving down.
The logic behind how short selling works is not intuitive to most people so here is a short example.
1) You go to your neighbor's house and ask to borrow 1lb of sugar. You promise your neighbor you will return the 1lb of sugar to them at some later date (a loan). You leave her house with the sugar you just borrowed and walk down the street to the local market, at the market you sell the sugar for $100. Two weeks later you return to the market and find a man selling sugar for only 80$. You buy the sugar for 80$ and carry it back to your neighbor from who you borrowed the sugar. After you give her the 1lb of sugar you owe her you have walked away with a $20 profit.
1) Borrow an asset from somebody
2) Sell that asset in the market
3) Buy the asset at a later date for a lower price
4) Return the asset to the person it was borrowed from
5) profit the difference between the sale and purchase price
"What happens if the asset I went short goes up in value?"
If the asset you short goes up in value you will either have to buy it at a higher value or wait until it hopefully comes down. The problem is that because stocks can in theory go up without limit you could, in theory, end up owing an almost infinite amount of money.
"What about dividends when I short a stock?"
The stock lender does not just give up the dividends they would have received. If you short a dividend-paying stock you are responsible for paying the diivneds the lender would have received. This means that you have to think carefully about the time horizon of your position.