How to Make Money in the Stock Market When the Markets Fall

Most people who do not invest in the Stock Market believe that the only way to make money in the marketplace is by following the rules governing the sale of any product, that is, “Sell at a higher price than the price at which it was bought”.

If this product is a financial instrument, such as a company's stock, in the above assertion is implicit the idea that the only way to make money is by selling the stock shares at a higher price than the one at which they were bought. To make this happen, obviously, there should be a rise in the stock price. Even though this is a way to make money in the Stock Market, it is not the only one.

It is also possible to make money in the opposite situation, that is, when the stock price falls. Of course, in order to make money when the stock price drops, we do not have to buy any shares, but rather we have to use a completely different mechanism that is known as Short Selling. Sometimes, this mechanism is unknown even by investors themselves.

Short Selling consists of borrowing a number of shares from the broker and selling them at the current market price, in order to buy them later at a lower price and return those shares to the broker. The difference between the selling price and the purchase price is our profit.

For example, if we believe the price of a stock is going to fall we can take advantage of this drop by Selling Short the stock. Suppose the stock is trading at $5 and we sell short 1,000 shares, if a few days later the stock price drops to $3, we will have a profit of $2 per share when we close the position. Thus, our total profit will be $2,000.

The example above is explained as follows: when we sell short the 1,000 shares, what we do is to borrow the shares from the broker. As the stock was currently trading at $5, we sell the 1,000 shares that the broker lent us for $5,000 (at that time we owe 1,000 shares to the broker). A few days later, the stock price drops to $3 and we buy 1,000 shares for a total cost of $3,000. Those 1,000 shares are purchased to be returned to the broker and as a result our total profit is $2,000 ($5,000 of the sale - $3,000 of the purchase).

So, the next time you hear the markets are falling, you do not need to lose your head!

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