A lot of people worry how they are going to make money in the market now that we are in a recession. When the economy slows down it is harder to make money in the market, but it’s not impossible. The United States is now in a recession and the market has turned against the traders in the sense that it’s not as easy to make a quick buck, but there is always money to be made in the market as long as it does not become stagnant. The market could be plummeting, but yet there will still be some traders who at the end of the day are not looking for the highest building to jump off of in the middle of Manhattan.
You might wonder how these traders escape the red. The market does not need to move up for you to keep your portfolio in the green it just needs to be moving. You are probably asking yourself how in the world you make money on a stock that is plummeting towards the ground. One way to keep your portfolio in good standing is to use a technique called “shorting”. Shorting works like this. Let’s say you discover that the stock (ABC) is overvalued and you know it’s going to drop like a rock once the market figures that it jumped the gun. This is an instance in which you would want to short (ABC).
When you short a stock you are betting on it to loose or decrease in value. Now, just stick with me. I am going to explain. When you call up your broker and you tell him that you want to short 100 share of stock (ABC) it means that you will now have 100 shares of stock (ABC) in you portfolio at a price of $10 a share, but here’s the thing you did not buy them. They have been loaned to you on an agreement that you will give them back at a later date. So you are in debt on the shares of (ABC) to the amount just 100 shares. You are not in the hole for $1000 dollars ($10×100=$1000) because you never bought them. Now this means that when you decide to cover the shares or give them back that you have either lost or gained on the shares based on the amount of change in the current market value from the market value of the stock when you shorted it.
Ok, let’s say that those 100 shares of (ABC) that you shorted at $10 dollars are now trading at $5. You would have made a profit of total profit of $500 dollars or $5 per share. The profit comes from you locking in (ABC) back when it was worth $10 a share and now it’s only worth $5. The broker that loaned you the shares has to pay you the $5 difference. If the stock had gone above $10 to $15 then you would have lost money because you would now have to pay the difference between the $10 locked in price and the new market price of $15. In this case you would now owe the broker $500 or $5 per share.
This is a little more complicated then just going long on stocks and hoping that they will go up in value, but it can be a very effective tool when you find yourself facing a bear market. It is also a good way to reduce your risk if you have a lot of money tied up in a stock that you think is going to go up, but you are not quite sure if there are any surprises waiting for you in the quarter ahead. You might decide to use shorting to hedge some of the risk in your portfolio. Check back with me next time to learn more about hedging…
