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What is Short Selling

What is short selling, and how do you do it? Short selling is selling something you don't have in an attempt to profit from a downward price movement. A lot of people have difficulty grasping this concept. How does it make sense to sell something you don't have? Allow me to explain using the following example. Imagine you are a produce seller at a fruit stand at a local market. Naturally, you probably know most of the other fruit and vegetable stand guys at your market and some of the other markets in your community. You probably even do some wheeling and dealing with them once in a while. You probably also know a few farmers that bring you fruit every now and then. Lets say that you know a farmer who sells peaches, but he always gives you a special price, only you. You don't normally sell to many peaches at your fruit stand, but you know that you can get them for cheap when you need to. Now, imagine one of the other fruit vendors at a nearby market comes your way commenting on how he wished he had some peaches because "they're selling like mad". You tell him "I'll sell you two cases of peaches for $5 a pound". OK, so you now have an obligation to deliver two cases of peaches to the vendor for $5 a pound. Now you go and look for you farmer friend who always give you a special price, he sells you two cases of peaches for $3 a pound. You deliver the peaches and make a profit of $2 a pound on two cases of peaches. Do you see how you sold the peaches even before you had them? If we transfer this example to stocks or futures, we don't actually know anyone that always gives us a "special deal" but we do make the assumption, or bet/speculation, that we can in fact get them at a cheaper price that what we just sold them for. This is how you can profit from selling something you don't have, in other words selling something you're short of.

Now, lets see how it would work if we were wrong. You have an obligation to deliver two cases of peaches at $5 a pound. You go looking for your farmer friend, but he is nowhere to be found. Because you are obligated to deliver peaches, you damned well better get them. You go to a neighboring farm, but the farmer is in no mood to give you a special deal and he is the only one selling peaches nearby. You are forced to pay $6 a pound for two cases of peaches. You deliver the peaches and take a $1 loss per pound on two cases of peaches. You thought that after dealing with the other fruit vendor you could find the product for cheaper, but you were wrong. So you cut your losses at $6 and fulfilled your obligation. There were no cheaper peaches because the supply you thought was available, turned into a scarcity and your demand was greater due to your obligation.

What is the difference between short selling futures and short selling stocks? With futures, there really is no practical difference between selling short or buying long except the strategy and indicators you might use. Indicators that work for long entries don't always work for short sells. With stocks, It's a different issue. To short sell stocks you have to have special approval from your broker and you have to have authorization to trade on margin. With futures, you automatically trade on margin, so if you have a futures account you are automatically authorized for margin and short selling.

Why can short selling be dangerous? Are the same dangers applicable in stocks as well as futures? Short selling can be dangerous because you can lose money just as easily as if you were making a long buy trade. However, there is a significant difference in the dangers of shorting stock as compared to shorting futures. With futures, because of low margins and high leverage there is always significant risk regardless of whether or not you trade long or short. Basically, the risks are the same either way. Theoretically, you could find yourself not only broke but in debt to your broker as well either going long or going short (buying or selling). However, with stocks the case is different. If you trade on margin, the most leverage you can get is 2:1, or 50% margin. When you are buying long, if you do not use margin, the worst case scenario is that you lose all your money and that is all. If you buy long on 50% margin, the worst case scenario is that you lose all you money and owe your broker an equivalent amount. For example, you invest $1000 on 50% and the stock goes to zero. You now lost your $1000 and you owe your broker an additional $1000 because you bought $2000 of the stock with only $1000 that you put up. With short selling, there is no ceiling to the amount you could potentially lose. For example, if you short sell a stock with $5000 (without using no extra margin leverage) and it skyrockets to the moon from $5 a share to $50 a share, you are now in debt $45 dollars a share, that's a $45000 debt from the 1000 shares that you shorted. The potential to lose money is much greater shorting stocks, so use stop losses or be vigilant or do whatever you do to stay on top and in control. The situation can be worse if you short using leverage.

If you don't believe me about this, look up a guy called Timothy Sykes. He made it his business to short penny stocks as they spiked. One day, he shorted a spiking penny stock that had very low liquidity (low volume). When the stock went for a second spike, there were not enough buyers for him to liquidate his position. He was locked in losing money while the stock price shot up with no one to neutralize his position. Learn a lesson from this, and don't trade products with low liquidity and low volume because you could very well find yourself locked in with no way out, left holding the bag as prices move against your favor. This is especially true with futures, because as we know, futures can be dangerous trading from either the long side or the short side. We're here to make profits, not take dramatic losses.

Is shorting stocks and futures bad for the economy? This is a complicated question. I could very well ask "Is buying stocks and futures and inflationary force on the economy?" I trade to make money, I'll do it long or short to suit my needs. Questions regarding how my speculating affects the economy are neither my concern, nor my interest until someone breaks down my door to drag me out. Then, it still doesn't matter anyways. I say, leave those types of questions for economists, governments, and central banks to figure out. After all, those guys are so smart they keep our economies and nations running smoothly anyways, don't they? Some countries actually outlaw short selling in stock markets. You can't outlaw short selling in futures, because it's contradictory to the nature of buying and selling goods, remember our peaches example? I think one country that outlaws short selling is France, I'm sure there are lots, but because I don't trade on all sorts of international stock exchanges I just don't know.

Should you short sell? Only if you know what you are doing. Only sell short if you have developed a strategy for yourself and you have practiced it for months, more than 3 months on paper with a journal. This is no different for going long. Only trade if you are comfortable with a strategy and you have practiced it until your paper trading is showing profit and growth.

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