SHORTING EXPLAINED
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Most ordinary people have never heard of it, but an understanding of shorting a stock (selling short) is vital to your understanding of how things work in the stock market.
To explain how shorting a stock works, I will first use a metaphor. Imagine you are the owner of a coin shop, a store that buys and sells rare and valuable coins. You have a friend who owns a rare gold coin that was made in Rome two thousand years ago. He will loan it to you for ten years.
You borrow the coin from him and give him a contract that says you have total control of the coin - the only stipulation is that you must give the coin back at some point (we will use ten years for our example) in the same condition it was loaned to you.
The coin is valued on the open market at $11,000.00
You then read in a magazine about an important discovery of coins in Italy. You think perhaps the coin you have borrowed may not be as valuable in ten years as it is right now.
So you sell it. You sell it for $10,000.00 to a regular customer of yours. (Remember, at some point you will have to buy it back, because you only borrowed it, you don't actually own it.)
Then word gets out that the important discovery of coins is actually twenty thousand coins that are almost identical to the one you sold for $10,000.00. The value of the coin you sold goes way down, and it is now worth $4,000.00 on the open market.
You call the person you sold the coin to, and offer to buy it back from him for $6,000.00. He agrees, (he knows it’s only worth $4,000.00) you buy the coin back, and then you give it back to the original owner, your friend.
Your profit on this transaction is $4,000.00. You sold it originally for $10,000.00 and then bought it back for $6,000.00. You made money on this transaction.
What happened?
You borrowed something, and then sold it (without owning it), then it went down in value and you bought it back cheaper than you sold it for...then you gave it back to the person you borrowed it from.
You made money by borrowing something, selling it, allowing it to go down in value, buying it back at a price less than you sold it for, and returning it to its owner.
This kind of transaction is very common in the stock market, except all the "coins" are exactly the same, and they are not coins. This transaction is called “shorting a stock” or “selling short”.
Here is how it works in the stock market:
Imagine GE stock is selling for $100.00 a share. You think the stock will go down, and in 12 months, it will be worth less than $100.00 a share. (You're a good chart reader! <G>)
You have $200.00 in your account. You call your stockbroker on the phone and ask him to loan you two shares of GE. (What you would actually say is “I want to short two shares of GE at $100.00”).He agrees, primarily because you have $200.00 in your account and you have the money to buy the stock back and give it back to him even if something goes wrong, and while you are borrowing it, you are paying him interest. Nobody rides for free.
You then sell the stock you borrowed from your broker for $200.00. The money goes into your account, and your brokerage account increases by $200.00 on the transaction.
You are now short two shares of GE in your account at a price of $100.00 per share. You have "shorted" GE - or "sold GE short".
But you know that at some point in the future, you must return that stock to the brokerage firm you borrowed it from, and to do that, you’ll have to buy it back. Your next question is probably, “Can I now buy $200.00 worth of stock with that money that went into my account?” The answer is “Uh.....no.” Lenders, especially brokerage firms, are not fools. You have to maintain a certain balance in your account so the brokerage firm does not lose money if you screw up.
Ok, you wait 11 months, and the price of GE is $50 a share. You decide to "cover" (exit or get out of) your short position. You call your stockbroker and tell him to buy two shares of GE for $100.00 He does so, and you give him back the two shares you borrowed from him. You took in $200.00 when you sold the stock, you paid $100.00 to when you bought it back. You now have $300.00 in your account, including a profit of $100.00 on your short sale transaction, and you have no short position on GE. You made $100.00 by selling something you didn’t own, and then buying it back for less and giving it back to the person you borrowed it from. You are now flat on GE. “Flat” means that you have no long position, no short position - you have no position at all. You are flat on this stock. Remember these terms - long, short, cover, and flat.
You “shorted the stock”, then you "covered" your short position (bought to cover), and now you are "flat."
The time factor could be 11 months or 11 minutes, but the idea is the same - you borrow the stock, sell it without actually owning it, it goes down and you buy it back and give it back to the person you borrowed it from. You keep the difference between the price you sold it for and the price you paid to buy it back.
WOW! Is this cool? I like it!
What can possibly go wrong, you ask?
Let’s say that you are short two shares of GE at $100.00.
2 months go by, and GE goes to $150.00 per share. You see on the chart that it now looks like it will go to $200.00 per share in less than 6 months. You decide to stop the pain and buy those two shares of stock back, or “cover your short position”. You now have to buy those two shares you borrowed for $150.00 each. You paid more to buy it back than you originally sold it for, and you lost $100.00 on the transaction.
Two more things: GE could go to $200.00, or $300.00, you don’t know, but at some point you must buy it back and give it back to the actual owner. Secondly, the broker will, under certain conditions, allow you to borrow more stock than you have money in your account to cover at a loss! This is called margin. Margin is the broker's term for loaning you money to buy stock. The more stock you buy, the bigger his commission, so brokers love margin customers, as long as they are prompt in paying any debts they accrue. In our example, had you wished, you could have shorted more than two shares of GE using the money in your account as security. This is an acceptable practice. But if the trade goes the wrong way far enough, you can lose not only your own money, but also the money you borrowed! On a short sale, if the stock goes high enough and you do not "cover" (buy back) your short position, you can lose more money than all the money you had in your account!
In fact, there is no limit to the upside price potential for any stock, therefore there is no limit to your potential loss when you short a stock, and this is what scares most people about shorting stock. When you buy a share of stock for $20.00, your downside risk is $20.00. When you short a share of stock, no matter what the price is, your downside risk is unlimited, because theoretically, there is no upside limit to how high the stock can go. This should not discourage you from shorting a stock, but it should make you sit up straight in your chair and pay attention when you short a stock.
If you have ever taken a suggestion from anyone regarding shorting a stock and they did not explain it fully to you, then I hate to tell you this, but they might not have had your best interests at heart.
Two more things - first, the brokerage firms regularly borrow stock from other brokerage firms if they need to. You could think of this as an automobile dealership that has a run on one kind of car, sells cars that it doesn’t own, and then buys them from another dealership to deliver to the customers that bought them. This fact, as you can imagine, could influence the movement of a stock price. You are one of the only people in the entire world that knows this, so no need to spread it around.
Secondly, about 70 years ago, the stock market crashed. Were the big brokerage firms responsible for the crash? Good question. The Securities and Exchange Commission was formed, and they decided to make a rule about shorting. The rule is - you must have an uptick on a stock price before you can short the stock short at the bid. If you own the stock already, you can sell it for any price you want, but if you are trying to short the stock, you cannot sell at the bid unless the stock goes up in price. The upticks may last two seconds or two months, but that's the law. Trading software is designed with a feature that incorporates the law into the software, so if you try to short a stock at some point and you machine says "tilt", that is probably the reason.
There are many investment and trading strategies and concepts involving shorting stock, so important that you really understand how it works in theory.
Note: this is a simplified explanation of selling short. There are other factors involved, and you should have your broker fully explain the specifics of shorting to you, or get a book that fully explains it, so that you totally understand it. It is possible to lose more money than you have in your account if you make a mistake when you short a stock, so make sure you understand what you are doing. You can drive a car without knowing how to fix it if it breaks, but if it breaks in the middle of the Mojave Desert, you are screwed.
The good news is that stocks go down much, must faster than they go up, and done correctly, shorting can be very, very lucrative. If you understand how to manage your risk, you don’t have to be afraid to short a stock. |
