Should You Still Short Sell Stocks?

The Dow was at 11,000 5 years ago. And as I write this, it's at 11,000 today! The Dow's price hasn't changed but the amount of stock held short (basically people betting that stocks will go down. Read below for an explanation of how short selling works) is higher than 5 years ago (Data Explorers.) What's up with that?

Why are people betting against stocks? We have a U.S. economy that isn't going well. Europe is trying to straighten itself out. Our government can't get anything done. We have no job growth. And home prices are still trying to stabilize.

The way to make real money in stocks (I am referring to buying stock index funds) is to buy or sell stocks in anticipation of news that isn't already factored into stock prices. So the Dow is at 11,400, not 14,000. Some of this bad news has got to be already factored into stock prices. Investors have given up on stocks, pulling $600 billion out of them in September of this year, putting the money in cash and bond funds. The PE ratio (that's a valuation measure) for stocks is at 12, below the average of 15. And interest rates are major low today.

• What if all the bad news is already factored into stocks?
• What if our economy does not double dip into recession?
• What if the European leaders can develop a plan to strengthen their banks?
• What if the increase in short selling is a sign that more people are coming late to the game of short selling?

Maybe the time to short sell or bet against stocks was when the Dow was at 14,000.

I'm thinking what would Warren Buffet do? The last time I had drinks with him (I wish!) he told me to buy when there is blood in the streets. And that's what Buffet is doing. He's going against the grain, against the herd, against the increase in short selling. He's using his own money to buy stock in Berkshire Hathaway because he sees value.

Here's how to short sell and how it works:

1. You borrow someone else's shares.
2. You sell them in the open market and keep the cash from the sale.
3. You wait for the price of the shares to drop. You then buy them back at a lower price, spending less money than you got from point #2.
4. You give the shares back to the person you borrowed them from, and you pocket the difference.

So why would you short sell something? Simple, because you think the price for whatever you are shorting is going to go down.

When you short sell something, you are selling it, which may drive the price down. And when you buy something, you may drive the price up.

So what happens when you short sell something and it doesn't go down, but it goes up? At some point you have to cover, and buy back the stock in the open market, which further drives the price up.

And that's the long and short of it!

Justin Krane is a certified financial planner who shows entrepreneurs how to unite their money with their life and business. Go to http://kranefinancialsolutions.com to receive your free Krane Financial Planning Toolkit -- great financial tools to help you with your life and business finances.

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