Selling Short and Going Long

• If two financial pundits are discussing the stock of the Gadget Corporation and one says, "I'm long in Gadget," what the investor means is that they own the stock of Gadget Corporation with intentions of holding it for some time. In other words, the investor expects the stock to increase in value and expects to realize a profit by selling or trading the stock at some future point. On the other hand, pertaining to stocks, to sell short means to sell a security before you actually own it.
  
  

Borrowing Stocks

• Financing a short sale works like buying stocks on margin. The brokerage will lend qualified clients the funds to finance these types of transactions, for a fee. In a short sale, the investor may borrow shares of stock from the brokerage or another investor who is "long" in the stock. Regulations require that if the company that the investor is selling short pays shareholders a dividend, the investor must pay the lender an equal amount in addition to repaying the shares.
  
  

Earning Profits

• When an investor sells short, there is an expectation that the stock price will fall and can be bought back for a lower price. For example, suppose Ms. Moneymaker is confident that shares of the Gadget Corporation are going to decrease and borrows 1000 shares at $10 per share from her broker to sell short. Ms. Moneymaker sells the borrowed 1000 shares at $10 each for $10,000. The price decreases as she expected to $8 per share. She buys the shares back to repay the loan at $8 each, totaling $8,000. Her profit on the short sale equals $2,000, disregarding transaction fees.
  
  

Paying Back the Shares

• If an investor's short sale works as intended and the price of the shorted stock falls, a profit can be earned. However, if the price increases, the investor must absorb the full cost of the loss. Regardless of how high the price of a particular stock may go on the market, the investor involved in shorting the stock must still buy the borrowed shares and repay them to the lender. Losses can be significant.
  
  

Warning

• Investors that sell short expect the price of the security to fall; if correct, the investor profits; if incorrect, the investor loses money. The investor conducting short sales is betting on their ability to predict the markets. Due to the volatility in the price of common stocks traded on open exchanges, short selling involves considerable risk for the novice investor. Consider that if future stock prices followed a predictable path, we would all have the opportunity to earn significant profits with little effort.