Tuesday, March 17, 2009

What is Shorting Stocks?

Traditionally, when you’re trying to make money in the stock market, you buy stocks at a certain price and hopefully that price will increase so you can sell the stocks at a profit. This method is called going long and is the most common way of trading stocks. However, there is another, lesser known way of trading stocks called short selling. Short selling is the opposite of going long. When you go long, you make money as the price of the stock increases. When you short a stock, you make money as the price of the stock decreases.

So how does this work? Say that you believe stock ABC is over-valued and its price is going to drop soon. You couldn’t make any money off of this prediction going long, so you must short the stock.

  1. First you contact your broker to borrow, say 100 shares of ABC. Typically the broker himself is not the one lending you shares, they are in turn borrowing the shares from another investor; however, this really doesn’t matter to you.

  2. You then immediately sell all 100 shares for the price at the moment – let’s assume $20 a share. This gives you $2000.

  3. This $2000 is not your profit. Obviously you can’t just borrow shares, sell them and be done. You still owe the person you borrowed the stocks from. The basis of shorting stocks lies in the fact that you borrowed 100 shares of ABC, not the value of those shares. You only owe the lender those same 100 shares back, regardless of their value.

  4. Now, a week later, the price of ABC has dropped to $10, as you predicted. You now buy 100 shares at $1000. 

  5. You give your broker the 100 shares, which means you have repaid your loan. You still have $1000 left over, which is your profit. (You will likely owe your broker a small fee for borrowing the stocks as well)
This could have gone another way though. For instance, say the price of ABC had increased to $30 a share. You eventually have to pay back the stocks you owe. Though brokers rarely if ever call in your loan, it is possible for them to do so. This means you would have to buy back the stock at whatever price it is at the moment, regardless of the price. Oftentimes when someone is shorting a stock, they will cover their positions to limit their losses. Covering means buying back the shares that you owe to repay the loan, even if it means taking a loss. In this case, you would have bought back 100 shares of ABC at $30, taking a loss of $1000.

Shorting stocks is usually done over a short time frame. When you borrow someone else's shares, you are essentially taking out a loan from them. They in turn charge you interest, as with any other loan. Therefore, the longer you keep their shares, the further the stock must drop to earn you a profit after paying back the interest.

There are risks involved with shorting a stock; more than going long. When you go long, your profits are infinite (the stock’s price can go up innately) yet your losses are finite (the price can only drop to zero). The opposite is true with shorting a stock. Your profits are limited and your losses are infinite. Now to be realistic, obviously no stock prices goes to infinity; they eventually hit a peak, but the idea is that a stock has more room to go higher than it does to go lower.

Shorting stocks is a debated topic. There are those that support it for various reasons. For instance, Warren Buffet believes that it is a useful way to reveal fraudulent companies. Yet, there is still a lot of unease around shorting stocks. It is associated with corruption, such as when hedge funds create false news to drive down the price of a stock and profit by shorting it. Many people view it unfavorably, simply because you are profiting off someone else's misfortune.

Personally, I don't like the idea of shorting stocks. When you go long, you are investing in a company. When you short a stock, there is no benefit other then the money you get. There is nothing produced. I see shorting stocks as an example of the way the stock market is turning into a money making scheme rather than a way to invest in a company, which is what the stock market is intended to do. 

How do you guys feel about shorting stocks?

6 comments:

  1. Very good definition of a short sale. Thank you.

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  2. To know when to buy and when to sell the stocks, you need to observe the stock so closely and then you can decide to buy or sell depending on the trend.

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  3. This is so much different with forex trading where short-selling is just like buying the other currency in the currency pair.

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