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The Basics of Short Selling

Short Selling Is Something Every Serious Investor Should Know How to Do

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Short selling is one of the least understood concepts among investors and traders.  So much so that even those with decades of experience in the market refuse to even consider short selling a stock. That is a big mistake.

If you were the owner of a football team, would you tell your players that you only wanted them to play offense and never defense?  Of course you wouldn't.  That would be silly because you would not be playing the game the way it was intended to be played.  In fact, your team would be at a huge disadvantage because your opponents would certainly be playing both sides of the ball.

It's the same with short selling.  The market is made up of buyers and sellers, and even though over time the market has an upward bias, it often goes through extended down periods where sellers are in control.  If you refuse to sell short then it will be difficult to make money during those periods.

There are a lot of complexities behind the mechanics of short selling, the good news is that you don't have to know -- or worry -- about any of them.  But if you want to have a general understand of what happens, here is the easiest way to illustrate it.

Imagine that your friend buys a brand new copy of a DVD -- it doesn't matter what DVD, but for the sake of argument let's say its The Godfather.  And let's say that you just happen to be at his house when it arrives and immediately ask him to borrow it (because it's your favorite movie).

Now let's say that you took the DVD and sold it.  It doesn't matter where you sold it, online, at a garage sale, or privately to another friend, but when you did you received twenty-five dollars for it. Now remember, you still owe your friend one copy of The Godfather, and at some point you are going to have to return that DVD to him.  Well, not that exact same DVD. 

A DVD is a standardized unit, meaning every DVD of The Godfather is like every other DVD of The Godfather.  The same goes for a share of stock.  Every share of Apple is that same as every other share of Apple. So you just have to return any DVD copy of The Godfather to your buddy and everything will be cool. 

Let's say that the copy you buy to return is from a wholesale distributor and it only costs you twenty bucks.  You return that copy to your friend, and pocket the difference between what you sold the original copy for ($25.00) and what the replacement copy cost ($20.00).   

This transaction is exactly the same as short selling, the only difference is that you swap a share of stock for The Godfather DVD.  And like this example, if you can replace the shares you borrowed for less than you sold them for, you make a profit.  And if not, you lose money on the trade.

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