Short selling stock is a fairly common way knowledgeable investors make money on stocks, even when share prices drop. To short a stock, you actually sell shares you don't own and then buy to cover the sale when the price drops. While that may sound odd, investors often choose this strategy over others for particular reasons in given situations.
One of the reasons you might short sell is to remain an active investor during tough economic conditions. Short selling enables investors to make money in the stock market even when they have a bearish outlook on investments. Without the ability to sell short you might have to sit on the sidelines for an extended period if you take a conservative approach to investing or lack confidence in the market.
Regardless of the broader market, you might short a stock to take advantage of an obvious drop in share value. Negative events, slowing growth, troubling earnings reports and poor forecasts commonly cause a stock to lose value. The challenge is getting in early as especially obvious problems can lead to swift price declines. You also need to decide whether you think the slide is a short-term blip or a long-term problem.
In some cases an investor might short a stock to hedge against the risks of investing in another. You might invest in one stock you expect to grow and find another company in the same sector that is in worse condition. Essentially, you're hedging against the unexpected decline of the sector as a whole by shorting one of the worst stocks in that sector. If things go wrong in that industry you've already got a negative bet in.
Challenges and Risks
Keep in mind that you might not always have the chance to sell short even if you want to. You need a brokerage account with a firm that has enough shares to loan you on the initial sale to use that strategy. Smaller companies may not have enough of the shares you want to support your play. Selling short also carries significant risk. If the share price goes up instead of down as you expected, you have to buy at the higher price to cover instead of the lower price you were hoping for. If you don't do it quickly you could lose a lot of money in a hurry on a sharp price spike.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.