Some have heard that real investors make money when the stock market goes up and also when it goes down. For many, this concept doesn’t make a lot of sense, but some would venture that it’s because the “real” investors’ holdings went up even when things were down.
One example of this would be Warren Buffett, also known as the Oracle of Omaha. Time Magazine noted on March 10, 2003 that Buffett felt the dollar was overvalued and the US trade deficit was dangerous. As a result he invested in foreign currency in 2002, which he still holds.
But for other investors, they make money when stocks go down because they are counting on stocks going down. These bearish investors are engaging in what is known as short selling.
What is Short Selling
Short selling is when money is made on a share of stock upon its price falling. What happens is that a short selling trader will believe that a stock is overpriced and will want to capitalize on it.
This investor will tie up some of his money into a stock (let’s say 100 shares in a stock selling for $10.00) because he believes that the share price will fall to $6.00. If it does, he will gain $400 minus trading fees. Interestingly enough, the short seller never actually owns the shares, and this is where it can become confusing.
An Analogy to Explain Short Selling
To explain short selling a great analogy is to look at Frank and SuEllen. Frank has a 1990 Plymouth Acclaim that he will not sell. SuEllen knows this, but believes she can make money off of his car while allowing him to keep it.
Here’s what happens: Frank goes on vacation and SuEllen has agreed to water his plants. What she’s also decided is that she is going to sell his Plymouth. She finds a buyer to purchase the vehicle for $1,000. Now, Frank is going to be home in a week, and SuEllen wants him to return with his car in the driveway [please note there is no time limit with short selling stock; this is merely an analogy].
If SuEllen can buy the Plymouth for a lower price than its market value at the time of sale, then she’ll keep the difference. If she cannot purchase it for a cheaper price, but it actually goes up in value, then she’ll end up losing the difference.
Essentially, if she can buy it for $600, she makes $400 on the deal. If the lowest price is $1,400, then she loses $400.
In the end, the only real difference in buying stocks to hold and selling stocks short is the belief in which way a particular company is going. There isn’t any magic to this program, just a means of trying to make money off of losses. If a stock is believed to go up, then the investor should buy and hold. If it’s believed to fall, then it should be sold short.