Many people even in this "enlightened" era, do not realize that you can make a lot of money if the market is falling. Well the fact is that you can, and there are 2 good ways to do it. One is to "sell short" and the other is to buy options called "puts". Today we want to look at the short selling game and try and give you some advice on how it works.

Selling short is not a new idea. It has been an acceptable practice since the beginning of the market. In fact after the crash of 1929, there was a remark people would use quite commonly. Have you ever heard the old term "hey don't sell him short"? Its a very old saying and the idea behind it is if you think someone is going to fall short of the mark, or miss the boat, or what have you, you would "short sell him". Why? Because if it comes true and the target did indeed fall or stumble, you were right. Well the term comes from the stock market. If you think the market or an individual stock is going to fall, you can short sell it and if you are correct and the stock falls, you will make money.

So, how can you make money on a stock that is falling apart? Quite easily, you simply sell it before it falls, and buy it back cheaper later. The difference between the two is pure profit. Suppose you think the XYZ company is ripe for a fall. They have been running up too fast and you feel that one of these days it's going to really see a pullback. You would call your broker and say something like this: "I would like to sell 500 shares of XYZ short please". Now let us suppose that XYZ is trading at $75 when you "sell it". Now lets also say you were right and it falls down to $65 the next week. At that point you would want to "cover your short sale". How? By buying the stock back at the lower price. So you call the broker and say: " I would like to cover my short sale in XYZ at this time." The broker would then buy back the shares you sold on the open market and the difference between where you sold the shares at and what you bought them back for (in this case $10 per share) is your profit on the trade. Thats it!

Where did we get the shares to sell in the first place?? Your brokerage literally "loans" them to you. When you called to say I want to sell the shares, they take their own stock holdings and loan them to you. So when you sold them, you were selling something you did not own. But because you borrowed them, eventually they will have to be replaced and that is what happens when you "cover". Basically you are replacing them. So the way to look at short selling is this: You borrow the shares at the current market price and sell them, basically saying to the brokerage, IOU 500 shares of XYZ. In our example XYZ was at $75 when we sold them so we took in $37,500. Then when XYZ fell to $65 a share we decided that was as far as as it would fall so we literally "bought them back" on the open market. So it cost us $32,500 to buy them back and replace what we borrowed, but there is a difference of $5,000 dollars between the two transactions and that money is yours! You sold shares you did not own, took in money, bought them back lower and made a very healthy profit doing it.

Well like everything there is risk involved. The risk in shorting a stock is that it might not fall like you thought. In fact it could go up! That is the problem. When you borrow the shares from the brokerage, they have to be replaced, and if the stock rises instead of falling, you are going to have to buy them back for replacement to the broker at a higher price than you sold them at meaning you lost money. This has to be avoided so it is important that the stock you short has every reason to fall.

Shorting is indeed a useful tool. Every day, stocks go up and stocks go down and only playing the upside limits your profit potential. To keep your risks at a minimum, remember these points: First, keep your short sales very quick in duration, do not sell a stock short and forget about it like its a long term hold. Try and align a poor market day with your short sales. In other words do not short a tech stock when the NASDAQ is gaining 50 points every day. Wait for the overall market to go into a dive and chances are your individual stock will fall too. If you can align a stock that has a "reason" to fall with a very poor market day, its possible to put many dollars in your account even on a one day trade.

With a run up in the market there are definitely going to be days when traders lock in profits and the market will be pulling back. Going short on a day like that, in a stock that is weak, or just missed earnings or what have you, will net you very good returns. Learn how to use this tool, and if you are not sure abut it, try "paper trading" for a while. Write down what price you sold at and what price you "covered" at and as you get better at the mechanics, then try your first one using real money.

Now we want to explore the other most common method of capturing profits in a falling stock.

There are options available that are called "puts" and puts are used when we think a stock is going to lose value. First what are they? They are options and you do need to know a bit about what they are. In their basic form, an option gives you the right but not the obligation to do something. In the concept of buying a put option, we are buying the right to sell a stock at specific price, within a specific time period. Why is that important?

Lets look:

Suppose you think the XYZ company is going to fall like a rock. They are trading at $50 a share now (say January), but you think they will be about $45 in no time. Well we can buy a "put" option against it. In our example lets say we buy the January $50 put and they cost us $2 each. (options are bought and sold in blocks called "contracts" with 100 "shares" to the contract, so we would be buying one contract of puts, for $200) that means we are indeed betting the stock will fall and if it does we will be rewarded. So how do we get rewarded? Like this: Remember with a put option you are buying the right (but not the obligation) to SELL a stock at a particular price. We have bought the right to sell XYZ for $50 per share until the 3rd Friday of January (all options expire on the 3rd Friday of the given month). Well, if we are right and XYZ is only trading at $44 by that Friday, we have an interesting situation here. We can sell XYZ for $6 more than they are trading for on the open market. We bought the right to do so, but that isn't the fun part. The fun part is that those options that we paid 2 dollars each for could be worth $7 or $8 each at that point! This is the beauty of option trading, the huge returns you can get if you're correct in your assumptions.

So, buying a put on a falling stock is a very good thing to do because if it keeps falling, your put option that you just bought is going to be worth a lot more shortly. Then you simply sell the option that you bought and pocket the profit. We know that one day there is going to be a pull back and knowing how to short the market or buy puts becomes extremely profitable.

More on Shorting

When the market is going through some major convulsions, the concept of shorting individual stocks naturally comes to mind. One thing that must be kept in mind and that is, you have to be very very careful when you are going to short something simply because companies are so aware of their stock prices now. Years ago a company could let their stock "ride" but now shareholders are quick to instigate lawsuits if a stock underperforms. So we like to see long trend down turns in the overall market before we short individual stocks simply because a company can and often does release news just to prop up its price. If the news is significant enough, it can quickly turn a falling stock into a rallying stock and that gets ugly if you are short. So, one thing to take into account is that you should monitor your short sales very closely.

One thing that often works as a timing indicator for when to short a stock is the exact opposite of the "10AM" rule, Or "gapout" rule. Here is how it works: If a stock opens weak and falls for a while, at some point it will settle out and probably turn back up for a while. Then if it is indeed going to be weak on the day, it will start falling again. We have found that if the stock falls below the price level it fell to during that first half hour, it will probably fall further. For example, let's say we think ABC is going down today and sure enough it opens at 50 and slides to 47 by 9:45. then it bounces up a bit to say 48 1/2 , but it cannot hold and back down it goes. If it falls below that first half hour low of 47, even by 1/2 a point, chances are great that it will continue to fall on the day. If you were considering shorting ABC that would be about the safest time to try it because it obviously couldn't even hold the first plunge price.

Does this method always work? No, nothing in the market is ever a guarantee, but as far as a "safe" way to try, it's as good as it gets. One other note we would like to express is that we often like to do short sales on a "daytrading basis" or in other words, if we are profitable on our short sale, we take the profit home that same afternoon. Again the thinking being that overnight they can brew up a decent press release and the next day the stock could gap up a bunch and leave you with no profit. Years ago, CEO's didn't take nearly as much notice of their stock price, but things have certainly changed. Now they need a strong stock price for a multitude of reasons. One is lawsuits, but they also leverage their stock price as a way of generating usable capital for expansion or rebuilding. So, we find it safest to treat shorts as a daytrade or a very short term hold at the very least. Naturally there are companies that just swan dive and keep going down, but if you watch, for the most part you will see them doggedly try their best to reverse back to the upside. Play your shorts quick and consider the downside "gapout" as a good entry point, we think you will find it useful.