Selling Short Explained

The other day I was IM'ing with a friend about selling short. We were discussing how I thought AIG, Goldman Sachs, and Morgan Stanley would drop after the news of Lehman Brothers going bankrupt. What I should have done was explain selling short in a previous blog post about my first and last experience of selling short in the stock market. So I'll do that now.

So what exactly is selling short a stock? It's making making money when a stock price goes down. The way it works is you borrow shares from your stock brokerage and you immediately sell the stock to gain cash, or "sell short". You then monitor the stock and decide when you want to buy it back (hopefully at a cheaper price), which is called "buy to cover". If you were successful at buying back the stock at a cheaper price, you keep the difference in price as profit.

For example, AIG stock was at $15 per share on Monday 9/15/2008. I "sell short" 2 shares of AIG stock on Monday from my stock brokerage and now have $30 cash ($15/share of AIG stock multiplied by 2). With my $30 cash, I buy back 2 shares of AIG on Wednesday 9/17/2008, which happen to be at only $2 per share. Doing a little math you can see that I only had to spend $4 to buy back 2 shares of AIG on Wednesday therefore profiting $26.