Bears, or those who expect the stock market to decline in price, make money by selling stocks short. In the process of short selling a speculator first selects a stock to sell short, often based on an analysis showing that the stock is overpriced, on stock charting patters that show a top in stock price, or because of expectations about future company prospects. The speculator then puts in an order to sell the stock short to his broker.
The broker finds a client who 1) has a margin account with the brokerage, 2) is currently in margin and 3) who owns shares of the stock the speculator wants to sell short. The broker borrows the shares from the client, often without the knowledge of the client, and sells them on the market for the speculator. (As an aside the IRS looked at charging capital gains taxes to the individual whose shares were borrowed without his knowledge – glad that didn’t pass.) The funds from the sale are then deposited in the speculator’s account. During the time that the shares are sold short the speculator will need to pay any dividends the stock pays to the individual from which the shares were borrowed.
If the bearish speculator is right about the stock, it will decrease in price. He can then buy back the shares on the market, giving them to the broker who will return the shares to the client. The closing transaction is called “covering” the short sale. Because he bought the shares for a lower price than he sold them for he will have made money.
Alternatives to doing a short sale are to 1) buy Put options, which give the trader the right to sell the stock at a certain price, and 2) buy Inverse ETFs, which are like highly speculative mutual funds that short a sector of the market for the investor. Note that any form of short sale is speculating or trading – it is not investing. At best it is purchasing insurance against declines in one’s own portfolio when done in a hedging manner (having both long and short positions). Time works against the short seller since the natural tendency fo the market is up, so short selling requires both timing and a strong stomach.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing