Did you know you can make money when a stock drops?

Yeah, pretty cool right? It’s called short selling. Instead of buying a stock, one is “shorting” a stock.

If one is to short a company, they have reason to believe that the company will lose market value considering a particular variable.

While it is always more fun and easier to be an optimist, sometimes it pays to be pessimistic about a particular company.

I personally believe that professional short sellers are some of the best market regulators as they naturally have the incentive to expose companies operating in an illegal or fraudulent way. Two examples of this are with Valeant, a pharmaceutical company, and Enron, an energy company.

If you would like to see how both of these companies were exposed and profited off of by short sellers, I recommend you watch the Netflix Original “Dirty Money” eps. “Drug Short” and the documentary “Enron: The Smartest Guys in the Room.”

Without going into extensive detail, I’ll give a basic explanation of how short selling works.

Essentially, to short a stock, one borrows a share of the company they want to short from someone else who owns shares of the company. They do this at some predetermined interest rate, however, we will disregard this reality for the sake of simplicity.

After finding the shares to borrow, the shorter turns around and sells the shares to someone willing to buy them. As an example, let’s just say the shorter sells them for $100.

Five months go by, and the stock that was shorted drops to $50 per share. The short seller then buys back those shares and sells them back to the original person or entity they borrowed them from.

In this example, the short seller would be making a profit of $50 per share in the span of five months. That would hypothetically be a profit of 10% per month minus the interest rate, not bad.

I think it’s not a bad idea for professionals to have a few short positions in a portfolio, as I have mentioned before, it is good to have inversely moving stocks in a portfolio.

If the entire market is up on a particular day, short sellers are losing money. If the entire market is down on a particular day, short sellers are profiting off of their strategic pessimism.  

The one company I look at as a strategic short is Tesla.

More of that next week for my final blog of the year.

DISCLAIMER: Cameron is not a certified financial advisor and all things stated should be considered solely as entertainment and NOT for financial transactions.