SHORT

This is VERY confusing to most beginners as the general concept is that (1) you make money when the price goes up and (2) you can not selling something that you do not yet own..

To illustrate this with an example, pretend that it is the begging of spring in the region of the world where you live.  You make your living by buying and selling snow shovels and you must pay a fee to rent space for any shovels that you store.  With the oncoming of spring, you realize that it is going to be difficult to get the current price for your present snow shovels so you have a sale and reduce the price to move your shovels and reduce your storage costs.  In effect, you are closing your long position in shovels as you no longer expect the price to go higher and you are no longer going to be holding any shovels.

As summer begins, you start to develop your strategy for your next season.  You realize that all the local stores have sold their snow shovels as well and with the onset of the summer heat, snow is the farthest thing from your buyers' minds.

You are also aware that as the winter months get worse and the snow begins to pile higher, the price of the snow shovels will then begin to climb ever higher as the principle of supply and demand will begin to take over.

You do not want to commit your money to buying and storing the shovels at this point because you believe that as summer moves further along, the price of any shovels still not sold will move even lower.  The other folks that are presently holding snow shovels can not find buyers in the heat of summer and would like to use their money for something else so they are willing to part with them for less and less as they wait longer and longer for somebody to buy from them.

You don't presently own any, buy you also believe that you could get more for a snow shovel next winter by asking less that others will be asking, but selling them for more than what you must pay for them in the first place.

Hmmm .... what to do ?

Simple !  Take orders now for delivery later to sell the shovels at the winter prices !

When you "short" a security, this is basically what you are doing.   Don't worry about the mechanics of how your brokerage firm does the paper work, just come to understand the function from your end of the trade.

As always, if you are to make any money on the trade, you will have to BUY low and SELL high.

Now stop and thing about this for a moment.  When will the prices be the lowest ?

Right !  At the END of the summer when people stop thinking about heat and begin to think about the coming snow season the price of the shovels will slowly begin to move up.

And when will they cost the most ?  Right again !  When everybody owns a snow shovel and there is nobody left to sell one to even at sale prices !

So ... the idea would be to SHORT, (sell the shovels you don't own yet), at the end of the snow season and then BUY, (to deliver the shovels that you promised to those that you sold to), the shovels back at the end of the summer.

Did you make money ?  Well, do the math.  Didn't you SELL when they were HIGH and then BUY when they were LOW ??

Yes.

Then you made money.  You simply used the system to allow you to sell to those that you would deliver to NEXT season and then buy those shovels just before you handed them over to those that you sold to.

Since you basically "borrowed" the shovels from your broker last season, and never really took possession of them, you were "SHORT" some amount of shovels that you were going to have to buy at some point to cover your outstanding order.  If you originated your position at a price higher than what you were going to buy your need to fill your commitment later, then you sold high and bought low and made money !

It is actually easier to get a better move on the downside than the upside as when folks begin to panic and sell, they usually move faster and longer then when they have to stop and think about whether they want to pay higher and higher prices for something when it is moving up.

The one wrinkle to all of this is that the SEC had to put some new trading rules into play to prevent what was a nasty little trick known as a "bear raid".  This was a stunt where a floor trader would take a short position and then start a rumor on the trading floor or news media concerning the relative security so that the price would begin to drop.  Of course this drop in price would lend confirmation to the original rumor and the selling frenzy would feed on itself.  This was VERY effective and profitable, but also very unethical to say the least !

The SEC Bear Raid rule states that you can ONLY short a security on an UP-TICK.   In other words, you can only go short ... if the stock is going UP in price.   So if you have a standing stop order during a trading range and you are waiting for it to fill below the support level, it is possible that the price could gap down, the stop would become "live" waiting for the price to go up, since this would be a short, and not fill until near the bottom of the price decline.   This would not make you any money as you need to short, (sell), at the top of the price move and buy at the bottom.

Simply be careful when using stop orders to initiate a short order.

I have been short 500 shares of XYZ since March 25.

On a breakout below $35, I have a stop set to short 500 shares of XYZ.

If my stop is filled, I will have a short position in XYZ.

In contrast to going short, see going long to understand the other side of this concept.