I Am a Shorter, and I Am Proud, by Mr. Chicken Brains To You
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 ancient coins in Italy. You think perhaps the coin you have borrowed may not be as valuable in ten years as it is right now. Or, you don't read the newspapers, you just check the chart on the coins and you see a top formation and you know it will go down just from the chart.
You sell it. You sell it for $10,000.00 to a regular customer of yours. He's fine on it; he wants the coin and he's saving 10 percent. (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 20,000 coins that are almost identical to the one you sold for $10,000.00. You wait....not yet, Billy Ray....not yet....not yet....
The value of the coin you sold goes way down. You call the person you sold your borrowed coin to, and offer to buy it back from him for $6,000.00. He agrees on the price, (he just saw 100 of the dang things for $4,000.00 each on EBay and he's not the happiest fellow at the party at this point) you buy the coin back, and then you give it back to the original owner, your friend.
You sold it originally for $10,000.00 and then bought it back for $6,000.00. You made money on this transaction. Your profit on this transaction is $4,000.00.
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, they are pieces of paper. 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 have $200.00 in your account. You call your stockbroker on the phone and ask him to loan you two shares of GE. He agrees, primarily because you have $200.00 in your account already and you should have extra money to buy the stock back and give it back to him even if something goes wrong. (What you would actually say is "I want to short two shares of GE at $100.00").
You then sell the stock you borrowed from your broker for $200.00. The money goes into your account, and you are up $200.00 on the transaction, with a total of $400.00 in your account.
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 some other stock with that money I collected when I sold the GE stock short?" The answer is "No." Lenders are not fools, especially brokerage firms. You have to maintain a certain balance in your account so the brokerage firm does not lose money if you screw up.
You wait 11 months, and the price of GE is $50 a share. You decide to cover your short position. You call your stockbroker and tell him to buy two shares of GE for $50.00 per share. (This is called "buying to cover a short position" – the end result is you no longer have a short position – you end up "flat" – no position in the stock.) Your broker buys to cover, and you automatically give him back those two shares of GE you borrowed from him when you initiated your short position.
You took in $200.00 when you shorted the stock, you paid back $100.00 when you bought it back to cover your short position. You now have a total of $300.00 in your account – your original $200.00, plus a profit of $100.00 on your short sale transaction. 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 "shorted the stock", then you "covered" your short position ("buy to cover order", not the same as "buy the stock"), and now you are "flat" on that position (you had a position and now you don't).
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 in price, 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.
What can possibly go wrong, you ask?
Let's say that you are short two shares of GE at $100.00 per share.
Two 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 because the stock went up in price.
GE could go up 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. Also, 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 brokerage firm's term for loaning you money to buy stock or short stock. The more stock you buy, the bigger his commission, so most brokers love margin customers, as long as they are prompt in paying any debts they accrue.
In our example, had you been cleared by your broker, you could have shorted more than two shares of GE using the money in your account as security. This is an acceptable practice for certain brokerage firm customers. 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.
Many people fear the idea of shorting a stock because they do not understand it. Shorting is a normal, everyday activity in all stock markets. Brokerage firms regularly borrow stock from other brokerage firms if they need to. You could think of this in the same way 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.
Finally, about 70 years ago, the Securities and Exchange Commission was formed, and they decided to make a rule about shorting stocks. The rule is (for stocks, remember) - you must have an uptick (a momentary increase in the price the stock is trading at) before you can initiate a short position. 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 short it at a point where the price (where it is actually trading) is declining. You can only open a short position when the stock goes up in price, or at a point higher than the "bid" price if the bid is not moving higher already. It's the law.
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. You must fully understand the risks involved, because it's your money. 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. The good news is that stocks go down much, must faster than they go up, and done correctly, shorting can be very, very lucrative.
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