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Introduction to Short Selling

Jul 1, 2008
So far, you have learnt how to make money when a stock appreciates in value. Basically, it is to buy when stocks/calls are at a low price and sell when stocks/calls move to a high price.

However, the best investors in the world can make huge profits no matter which direction stock prices take! When Enron Corporation's stock price plunged from US$90 to US$0.30 in 2001, after it was found to have hidden billions of dollars in losses through accounting fraud, and people had their entire life savings wiped put, there were also many smart investors who made millions in the process!

When the Dot Com bubble burst in 2001 and stock markets plunged by over 50%, smart investors made huge fortunes at the same time! Wouldn't you like to learn how to do this? Wouldn't you like to make huge profits no matter what the market does? While most people have to wait for a bull run in the stock markets to make money, you will be able to make money in a bear market and even in a prolonged period of consolidation (i.e. stock prices move sideways).
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What many people do not know is how they can make money when they expect a stock's price to FALL. Traditionally, when stock traders expect a stock to fall from its current price of say, $50 to $35, they would SHORT SELL the stock. What this means is that they will SELL the stock NOW at $50 (without owning the stock) and they will then BUY it back later at the lower price of $35. So, by selling HIGH ($50) and buying LOW ($35), they make a profit of $15 per share.

One question that confuses most beginners is, "how do you sell stock you do not own?" Well, your broker will LEND YOU the shares to sell at the high price. You must then go and buy the shares at the lower market price (within a certain period of time) and return it to the broker. This entire transaction is done automatically when you short sell stock (also known as "sell to open" and "buy to close").

Short Selling Leads To Unlimited Risk of Loss

However, I do not encourage you to engage in short-selling of stocks unless you are extremely experienced. This is because if the stock does not fall as expected, you can suffer unlimited loss.

For example, let's say Osim's stock price is $1.60 and after posting disappointing financial results, you expect the stock to fall to $1.40. You short sell 10,000 shares at $1.60 and collect $16,000. However, you must buy back the shares within two days to return it to your broker. What if Osim's share price suddenly surges to $2? Then you will have to buy 10,000 shares at $2 and fork out $20,000. You suffer a loss of $4,000!

Talk to most people and the majority of them would only understand the concept of making money only when stock prices rise in value. In fact, many people only understand the concept of buying something at a low price and selling it at a high price.

As a result, the masses tend to panic and fear recessions, downturns and bear markets as it could wipe out their hard earned savings. They tend to sit on the sidelines until the time comes when the economy and market sentiment improves and prices start rising again.
About the Author
Adam Khoo is an entrepreneur, best-selling author and a self-made millionaire by the age of 26. Discover his millionaire investing secrets and claim your FREE bonus chapter of his latest bestselling book 'Secrets Of Millionaire Investors' at Secrets Of Millionaire Investors.
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