How to make money when you see overpriced stock

Picture this. You're on iPredict, you see a stock price for a future event that you are sure is not that likely. Doesn't this overpricing create an opportunity to make money?

Certainly it does, if your instincts are correct. Here's how.

Sell. Even if you do not own stock, you can sell it and make money the lower is the future price of that stock.

Selling stock you do not own is called short selling, and on iPredict short selling works exactly the same as if you were selling stock you do own.

Before I explain the mechanics of what is going on, the key thing to know about short selling is that your earnings from short selling are the exact mirror of the money you make when buying: when you buy a stock, you make money if the stock's price goes up. When you short sell a stock, you make money if the stock's price goes down.

How much money do you make from short selling?

When short selling, the money you earn per contract is the difference between the stock price when you short sell, and when you "cover" or pay or stock you shorted.

An example might help clarify. Let's say you see a stock that is trading at 80 cents for an event that you are sure will not come true. That is, you think this stock will close at $0, and is currently massively overpriced. To make money on this overpricing, you need to short sell this stock. Here's how.

Sign in, and click Trade on this stock. In the Standard or Advanced trade interfaces, tell iPredict you want to sell the stock. You can do this even if you don't own any of this stock - that is why this is called short selling. Say how much you are willing to sell this stock for, as you would if you actually owned this stock, and confirm your trade.

Congratulations, you have just sold stock you don't own, and you are making money every time the price of the stock falls. How?

What you have just done is a) borrowed stock and sold it for money to a buyer on iPredict, and b) committed to paying for the stock you just borrowed some time in the future at whatever the price is at the time you decide to pay.

Now think about it. You've just sold shares you don't own and got the money for them up front. That's your revenue and it's locked in. But your costs - the money to buy the shares you just borrowed and sold - will only be determined in the future when you purchase them on the open market to repay the lender. The lower that future price, the lower your costs, and the bigger the difference between the revenue you received up front and the cost of the stocks you sold.

In other words, when you short sell, you make when the price of stocks fall.

One final note: when you short sell, the iPredict takes $1 off you as a deposit to cover the worst possible outcome, which is that the stock closes at its maximum price of $1. When you cover, you get your dollar deposit back at the same time you cover the cost of the stock you purchased. That's why money comes out of your account when you short sell and comes into your account when you cover - without the deposit it would be the other way around.

Clear as mud?

Check out our tutorial page for a video and a written tutorial on short selling. Short selling is trivially simple to do on iPredict, even if the theory behind it takes a bit of getting used to.

Update: from Australia, a ban on short selling is credited with buoying a volatile market.

An Australian Securities and Investments Commission ban on short selling, designed to reduce volatility and improve liquidity in the local equity market, also buoyed the share market today and lifted shares in companies that had recently been targeted by hedge funds.

On its face, banning short selling seems a very odd way to raise liquidity. If I see stock that is overpriced and cannot sell it because I happen not to own any of it, I'm not likely to instead dive in with offers to buy. Limiting the set of traders who can move a stock's price down to those who happen to have taken long positions on shares before the crisis sounds like a recipe for inefficiency - an arbitrary introduction of downwards rigidity in stock prices does not sound helpful even if prices are volatile. Should we expect it to be helpful to prevent volatility from being expressed in trading if that volatility is grounded in genuine uncertainty?