The Transaction
Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. You decide to take the plunge and short 100 shares. For this example, we ignore margin requirements and deal exclusively with the monetary implications of the trade. The transaction is straightforward–most online brokerages will have a check box that says "short sale" and "buy to cover."
One of two things can happen in the coming months:
| Borrowed 100 shares of XYZ at $65 | $6,500 |
| Bought Back 100 shares of XYZ at $40 | -$4,000 |
| Your Profit | $2,500 |
| Borrowed 100 shares of XYZ at $65 | $6,500 |
| Bought Back 100 shares of XYZ at $90 | -$9,000 |
| Your Profit | -$2,500 |
Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you want (just as with buying long).
Shorters use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.
One indicator specific to shorts that is worth mentioning is short interest. This reveals how many shares have already been sold short. It's a dangerous sign if too much stock is sold short before you initiate a new short position.