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The stock market has generally gone up over the long run, and most investors choose to invest in ways that allow them to participate in the upward movement of stocks. However, if you discover a situation in which you believe that a stock is more likely to go down than up, then using a strategy known as short selling can let you profit from your beliefs if they're right. There are a couple of different ways you can implement a short-selling strategy, one of which involves only shares of stock and the other, which uses options.
What shorting a stock means
The more common way to bet against a stock is to use a traditional short sale. In this method, you borrow shares from someone who already owns the stock, committing to return the shares to the shareholder in the future. Then, you sell the stock that you borrowed, keeping the cash proceeds for yourself.
The idea behind shorting a stock is that you hope that the share price will go down before you decide to close out your short position. That way, you can repurchase the shares you sold for less than the proceeds you received, pocketing the difference as your profit. For instance, if you borrowed shares and sold the stock at $100 per share and you later were able to buy it back at $75 per share, then the difference of $25 per share is yours to keep.
If you're wrong, however, then short selling can be costly. In the example above, if the stock rises to $125 per share, then you'll end up having to find the extra $25 per share out of your own pocket in order to buy back the stock and return it to the person who let you borrow it. Indeed, because there's no theoretical limit to how high a share price can rise, the loss on your short sale can exceed the cash proceeds you got from the initial sale -- something that many newer investors don't realize is even a possibility.
Using options to short a stock
Another way to short a stock is to use an options-based strategy. To create what's known as a synthetic short position, you can buy a put option and sell a call option at the same strike price and with the same expiration date. If the stock falls, then the value of the put option will go up. If the stock rises, then the value of the put will fall, and the value of the sold call option will rise, creating a loss on the overall position that you'll have to pay back in the same way you would an ordinary short.
Selling short using an options strategy has some features that a regular short sale of stock doesn't. For instance, the options-based strategy imposes a specific time limit on the short position, because once the options expire, you'll either have to close out the position or meet the obligations that the options contracts place on you. With a traditional short sale, there's no predetermined time limit, and that can give you more flexibility to profit from a long-term bearish view on a stock.
Should you short stock?
Selling stock short is seen as riskier than owning stock, and that stems mostly from the potentially unlimited losses that you can suffer. When you own a stock, you can't lose more than what you paid for the stock. Short a stock that goes up tenfold, however, and you can quickly suffer catastrophic losses.
That said, short selling has its place within an investor's strategic toolbox. There are times when you're willing to take on some risk in order to profit from what you see as a likely future decline, and both traditional and option-based short positions can give you that opportunity.
Relatively few investors use strategies that involve shorting stock, choosing instead to focus on stocks with a positive outlook that are likely to gain in value. For those who believe they can foresee when a company will go through hard times, however, knowing how to short sell a stock can be valuable in providing another way to make money from the stock market.
The article How to Short a Stock originally appeared on Fool.com.
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