How does one profit from Shorting stocks?

This is how shorting works...

Let's look at a real example. General Motors (GM) stands at $32 right now. So, you think this company is going to go broke eventually?

One day you decide to BORROW 1000 shares from a GM investor and sell his shares with a promise to give him back his shares sometime later. You do this because you think GM stock is going to go down.

Let's say that GM does go down. Let's say that their stock price falls from $32 all the way to $2.50! Wow. GM is in big trouble indeed. You know what you're doing! Now, that GM is at $2.50, you decide to buy back 1000 shares and give the shares back to the original owner, and you keep the difference. You just made a killing!

What's the difference?
Let's review what happened:

1. You borrowed 1000 shares.
2. You sold 1000 shares at $32. You had $32000 cash at this point.
3. Later you bought 1000 shares for $2.50. That cost you $2500. (But you still have $29500 cash.)
4. You gave back the 1000 shares to the original owner.
5. You're left with 29500 dollars profit! That's the difference. That's what you keep.

But what if GM didn't go down but up? Let's say that you borrowed 1000 shares and sold it and the stock price went up from $32 all the way to $50. You were convinced that GM is in trouble, so you wait a little more. GM jumps up to $90. Now you think this should be the TOP of this rally. GM is going to go down after this rally. But GM marches north. Now it's $100. You are in big trouble now. You're dead now. You don't know what to do. Should you buy it now or sell it or keep it or what??? Finally, you decide to get out at $127.80!!!

You decide to buy back 1000 shares for 127.80. Buying 1000 shares at 127.80 is going to cost you 127800 dollars! How in the world are you going to get so much money!?

Well, let's say that you sell your house and buy the 1000 shares and give it back to the owner.
Ok.

Problem solved.

Oops... But now you have no house! :-(

This is how short selling works.

Actually, it is a lot easier than this. When you want to sell short, you don't have to worry about borrowing. That happens automatically behind the scenes. All you have to do is type in the box how many shares, what symbol, and then select "SELL SHORT" and click on Send Order. Five seconds later, you're going to get a little message that says YOU SHORTED 1000 GM.

There are a couple of rules that you cannot break. One rule is that you cannot borrow more than 566 million shares of GM. That's because there are only 566 million shares in existence. How do we know that? We look at the Company Profile, and it says 566M shares outstanding.

SHORT INTEREST is a number--it tells you what percentage of the stock is borrowed at this moment. GM's short interest is 7% right now, which means that 7% of shares are already borrowed: 7% of GM shares are shorted at this moment. If you click on the link below, you'll see the short interest chart for GM.

When the short interest is very high that means a lot of people bet on the company's failure. Stocks that have very high short interest often jump up several 100% in a couple of days. So, before someone wants to sell short, he has to look at the short interest chart and see what it shows. If it's too high, he shouldn't sell short, because it's too risky.

Here is another rule: Before you sell short, you have to have LOTS OF MONEY on your investment account or else you're not allowed to sell short! In reality, you don't sell your house after you realize that you are in big trouble. You have to have lots of money up front. If you make a big mistake in short selling, your entire account can end up with 0 dollars. That's bad.

If you buy a stock, the most you can lose is your money that you invested in the first place. But if you sell short, then you could lose more than you can imagine. You can lose your house and your shirt! You can actually end up in millions of dollars of debt. That's very bad.

Many people think that short selling ruins companies and hurts businesses. That's nonsense! Selling short only hurts those investors who hold the stock while it goes down and then sell their shares at the bottom. The stock itself may go down, but if the company is financially stable, then the stock will rebounce! Why? Because a good company at a cheap price is a pearl. It's a bargain. A real treasure is not going to stay buried forever!

Market crashes that are short give us clues that the economy is stable, that there's a treasure in the country. When the economy is strong, there may be a few small crashes but the stock market quickly bounces back. If a steep decline lasts a very long time, it usually tells us that something is seriously wrong.

If a company's stock goes down and stays down, it means there's no treasure there. Those kind of declines happen not because of short sellers. They happen when investors unexpectedly learn that they are riding on Titanic, and they dump their shares. That's what happened in Enron and Worldcom. These companies went down. They didn't go down because of short sellers. Short selling doesn't cause companies to go bankrupt. Usually careless or crooked CEOs are responsible for that...