There are a lot of criticisms of short selling and it seems probably no more than 5-10% of the investing public uses this tool. There’s a pretty good reason the public in general doesn’t short-they don’t understand how to do it and they are worried about the consequences of going short. I’ve heard the claims-“you expose yourself to limited gains and unlimited loss”. This really isn’t true, when is the last time you heard of a limitless stock? Besides, a well placed stop can trigger at market and get filled immediately whenever you chose. So the notion of unlimited losses is off the table, the other claim-“you are limited to 100% gain” and that would be if you shorted and the stock did an Enron. Well, pratically speaking, that’s not true either. I’d try to explain myself, buy Martin Zweig in Winning ON Wall Street did such a good job, I’ll use his example(by the way, under “resources and concepts”, below the tagboard, there is a recomended reading list link in which you’ll find this book).
Here’s the example: You short 100 shares @ $50 and the stock falls to $25. That’s a $2500 profit for you. If you started with $5000 in equity, your total equity now in the account is now $7500. At this point the stock is trading at $25, which is $2500 per 100 shares. To maintain 100% equity behind your position, you only need $2500 in the account. You then pyramid (without using margin), selling short an additional 200 shares. You now have 300 shares short, which would require the $7500 backing. If that stock were to go to “0”, you’d make an additional $7500 in profit. So your total profit would be $10,000 on a $5,000 investment, which is 200 percent. But it doesn’t have to stop there, suppose the stock drops from $25 to $10. Now you have 300 shares of a $10 stock. The total capital you need in the account without margin is $3000. Remember, you have $7500 in capital. On the drop from $25 to $10 you’ve made 15 points, or $1500 per hundred shares, which is $4500 in profit added to your $7500 equity. that gives you $12,000 of equity when the stock is at $10. You’re only short 300 shares. You could then short another 900 shares at $10 without putting up any more money and without using margin. Let’s say you did that. Now, at $10 you’re short 1200 shares. Now the company goes broke to “0”, you’ve made $12,000 on the drop, but you had an additional $12,000 in the account when the stock was $10. So your total ending equity is $24,000 when the stock is at “0”. Since you started with $5000 you have mad almost fivefold profit. If you want to, you can short a lot more on the way down. You can short every $5 drop in price or at any other price so your profit on the downside is virtually unlimited. Or if you have a $50 stock that falls to $25, you have $7500 in equity in the account and only need $2500 to maintain the position, you can do whatever you want with the extra $5,000.
One last thing from Martin’s book-If you are on the long side and the stock goes from $50-$100, you can’t pullout any money unless you go on margin.
Well, it’s a good book and it is a good strategy that I have heard in no other place. One of the reasons I like to have a short position in my account is, as it makes profit, I immediately use those profits to finance other trades. Also, as I have mentioned before, fear is a stronger emotion than greed therefore shorts tend to move much faster making you money very quickly. I know it’s a lot and it’s late. Bookmark this post and reread it after you’ve had your coffee, it’ll make sense at some point and you’ll see the advantage of being short