Short Stock Picks

Written by Elise Allen
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Most people associate a down stock market with losing money. For savvy investors, however, down markets simply present another opportunity to make money. There are two ways an investor can make money as stock prices fall: with put contracts or short selling. Put contracts are those which allow the contract holder to sell a stock at a specific price on a specific date. First, you buy a put. Second, watch the underlying stock fall below the contract's strike price. Third, you can buy the stock on the open market and sell it at the higher strike price, and pocket the difference.

Short selling is a little different, and riskier, than buying puts. To sell a stock short you must borrow shares from your brokerage house. You then sell the shares on the open market, in hopes the stock price will fall. When the stock price falls, you can then buy back the borrowed shares and pocket the difference. Buying back the borrowed shares is called "covering" the short position.

Shorting a stock carries a high degree of risk, as your potential for loss is theoretically unlimited. When a short works against you, you are forced to buy the stock at a higher price. You must make up the difference between the short sale price, and the cover buy price. Market makers, those who set a stock's trading price, can temporarily drive a stock's price higher to force short sellers to cover. This is known as a "short squeeze" and increases the risk of loss when shorting stocks.

When to Short Stocks

To increase your chance of success when buying stocks, you must have a clear understanding of the general market trend. Three out of four stocks will follow the general market. To decrease your risk when selling stocks short, you will want to short stocks only when the market is trending lower. To short a stock when the market is strong is a good way to lose money.

Shorting stocks also requires a solid understanding of technical analysis. A stock will flash sell signals before topping out and moving lower. A short seller must be able to identify the difference between a stock which is topping out and one which is in a sustainable uptrend. Technical analysis is the only way one can identify sell signals and short with confidence.

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