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How Shorting Stocks Work

When I first started trading, shorting stocks seemed foreign and scary. The concept of shorting was a little hard to grasp also. But I have since learned how to embrace the idea and use it as an integral part of my trading strategy.

I will explain how shorting works with a very simple example. Everyone knows about the Tickle-Me-Elmo’s and how popular they are. Around Christmastime these Elmo’s can get very expensive as people bid the prices up on auctions.

Let’s say you know that these Elmo’s are going to lose their value in a few weeks. You ask your friend to let you borrow his. So now you haven’t spent a single dollar and have possession of an Elmo. You quickly go out and sell the Elmo at market price for $100.

A week after Christmas the price of the Elmo’s drop to $25, so you go to the store and buy one with the $100 you collected last week and give the Elmo back to your friend.

So let’s review: you borrowed an Elmo, sold it and pocketed $100 and bought it back for $25. You have $75 left as your profit.

This is exactly how shorting stocks work. If you believe a stock is about to drop in price, you short it by selling it first and collecting the money. Once the price has dropped, you cover by buying the stock back and profiting from the difference.

Now let me explain why shorting is so dangerous. When you buy a stock the normal way, expect it to go up and it doesn’t, the most you can lose is all your money. If a stock is $5 and drops to zero you have lost all your money.

With shorting if a stock goes up you lose money. If a stock is $5 and goes to $10 you have lost all your money. If it goes to $20 you now owe your broker money. In theory a stock can go up forever so the losses can be unlimited.

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