Just the other day, a friend came to me with a serious and specific question.
He’s been watching the markets, and the headlines, and wanted to know if he should “sell everything and go to cash.”
I laughed and asked: “Do you know something I don’t? Do you know, for sure, that the sky is falling?”
He doesn’t, of course. But I could tell from his comments that he was worried about several things – that China was about to implode, or could in the near future – and that he wanted to protect his investments.
Without missing a beat, I suggested he just “short” China and make a ton if it crashes.
This wasn’t an off-the-cuff quip. Investors who’ve followed me for a long time know that one of my core beliefs – a mantra, really – is that there’s always a place and a way to make money.
I believe you can find ways to make money in any kind of market – bull, bear or trendless. And I believe that because you can make money on both “sides” of the market – the long side and the short side.
That’s why I love trading and investing. It’s possible to make money when something… anything… everything… goes up.
And it’s also possible to make money when something… anything… everything… goes down.
Three Keys to the Market’s “Other Side”
Unfortunately, most people don’t know how to make money on both sides of the market.
Everybody knows that if you own stocks, bonds, commodities, gold or real estate – or any asset in any asset-class for that matter – you make money as long as prices are rising.
But asset prices don’t rise forever.
Sometimes prices dip down. Sometimes they crash. Sometimes they recover quickly, sometimes they recover slowly and sometimes they never recover.
You can make money in any market if you know that nothing goes up forever. With that understanding, you’ll not only avoid big losses when prices drop – but can actually make a ton of money when that happens.
It’s not hard. There are lots of ways to make money when things go down. And you don’t even need to know them all.
In fact, you just need to understand the three most popular ways to play price or market declines. Those three key strategies are:
- Selling short, more commonly known as “shorting.”
- Buying “put” options.
- And buying “inverse” exchange-traded funds (ETFs).
Today I’m going to tell you about shorting. In some upcoming columns, I’ll explain put options and the inverse ETFs.
On Wall Street, the term for owning something is “being long.” If you own shares of International Business Machines Corp. (NYSE: IBM), then you are “long” Big Blue.
If you own gold (it doesn’t matter if you own gold bars or a gold stock) and I come to you and ask, “Do you like gold?”… then you could say, “Yes, in fact, I’m long gold.”
That tells me you own some gold.
The opposite of long is short. The opposite of being long something is being short on that same asset.
That’s where the terms “short selling,” “selling short” and “shorting” all come from. They all convey the same thing – the opposite of “going long,” or “being long.”
Instead of buying and going long on an asset – in essence, betting the price will go higher – you can short that asset and bet the price will go lower.
It’s really simple. You either tell your broker you want to short XYZ stock or look on your trading platform (online broker) and find the button or link for shorting.
The process, for the most part, is as simple as buying a stock.
A Step-by-Step Look
Here’s what happens behind the scenes.
When you sell a stock short, you are selling that stock to someone who is buying it from you.
However, you don’t actually “own” the stock that you’re selling.
Let’s say XYZ just ran from $50 to $100 a share. And you want to short it because you believe some developing news about the company – for instance, bad earnings or a nagging legal case that won’t go away – will spur profit-taking and cause the stock to fall back to $50.
When you short-sell the stock, you are actually selling it to someone. The person who buys the stock from you pays you $100 each for all the shares you sell them. He doesn’t know you don’t own the stock you’re selling – and he doesn’t care. All he knows is that he has to pay for the stock he bought and he wants the shares to go into his account.
Behind the scenes, to get you the XYZ shares that you’re selling, your brokerage “borrows” them from another person’s account. Your brokerage delivers those shares to the buyer, and now you’re done with her.
You end up with the cash – the $100 a share – in your account.
Now you are “short XYZ” at $100 a share.
If you’re right and XYZ falls to $50 – and you want to get out of the short position to lock in your profit – you would buy shares of XYZ. When you buy back shares you’ve shorted, it’s called “covering” or “buying to cover.”
So, you “cover” your short by paying $50 for XYZ stock. You pay $50 out of your account, and the seller has to deliver XYZ shares to your account. Now you have XYZ shares in your account.
But you owe someone shares of XYZ that your brokerage borrowed on your behalf.
You don’t have to do anything. Your brokerage knows whom it borrowed those shares from. The broker simply take the shares you just bought out of your account and places them back into the person’s account the shares were first borrowed from.
This behind-the-scenes maneuvering is completely permissible.
Your brokerage agreement – everyone’s brokerage agreement, in fact – allows your broker to borrow shares from your account any time it wants. It never has to tell you. You’ll never know. And it doesn’t matter to you.
The only thing that matters to you – or anyone else – is that when you go to sell the shares in your account they are there. If you sell shares from your account that your brokerage already lent out to someone, it doesn’t matter: The broker will simply borrow them from someone else’s account so you can deliver them to whoever buys them from you.
But here’s the complete picture of what happened financially – for you.
You started by selling stock for $100. You got that cash in your account. You’re up $100, out of thin air. But once the stock drops, as you predicted it would, you had to use $50 to buy back the shares you borrowed to start this all off.
So you received $100 a share at the outset – when you shorted the stock. And you paid $50 a share when you “covered.” So you ended up with a net total of $50 a share in your account.
You just made $50 a share – from a stock that went down.
A Look Ahead
There is one big difference between going long and going short.
I’m talking about the risk.
When you’re short a stock, you are expecting it to fall in price.
But what if, instead, it goes up? If that happens, you have to buy the stock back – cover it – at a price higher than what you sold it for.
If XYZ didn’t go down – but jumped up to $150 – to get out of the position (cover), you would have to pay $150 a share.
Here’s how the math would work in this situation.
When you shorted XYZ at $100 a share, you initially received $100 in your account. But with the stock now at $150 a share, you’d now have to come up with $150 to “cover” – to buy it back.
So you lose $50 a share.
When you go long on a stock – buy it – your potential loss is limited to the amount you invested… what you paid for the stock. In other words, when you buy a stock and it goes down, your loss is said to be “limited” because the stock can only go to zero – and no lower. That’s comforting.
Theoretically, selling short leaves you with unlimited risk. That’s because a stock can keep going higher and higher. As with any risk, however, there are ways to manage this.
That’s your quick lesson on shorting.
It’s a quick lesson because I’m not going into “margin” – using borrowed money for “leverage” – and how you need a margin account and what brokerages charge you for margin. If you have any questions on that topic, ask your broker. You can ask him or her how that works and what the firm’s charges are. Or you can read the account agreement the brokerage made you sign.
And if you have any questions about the topic of shorting, send them in right here. I’ll answer them.
I’ll also tell you what’s going on with China and why my friend is worried that the Chinese stock market could tank and knock down U.S. and global stock markets.
And I’ll tell you how to use put options and inverse ETFs to make money when things go down.
The financial markets bring us lots of opportunities for profit – and not all of them are on the long side.
I look at everything.
And that’s why I believe there’s always a place to make money.
[Editor’s Note: As Shah said here today, he looks forward to your comments and questions. The process is simple – you can just post the below.]