Trillionaire Term of the Day - January 26, 2009 - Short Selling

Short Selling

Short selling is one of the best ways to make money in a downward-spiraling stock market like the one we are experiencing today.  When an investor goes short on a stock, he is expecting the share price of the stock to decrease in the future.  The opposite of shorting a stock is being long.  If you are long on a stock, you are expecting the share price of a stock to increase (typical method of investing).

When you short sell a stock, you borrow shares of the company from your broker.  Eventually, you must buy back the shares that you have borrowed, a process called covering your short.  If the share price has dropped since you first borrowed the stock, you can buy back the stock at the lower share price and make a profit on the difference.  But, if the stock price has gone up since you borrowed the stock, you must buy the stock back at a higher price when you are covering your short.  So, when shorting, you better hope that the stock price goes down if you want to make some money!

Let’s do an example to see how people make money by shorting stocks.  If I decided to short 100 shares of Wal-Mart (WMT) today, I would be borrowing 100 shares at $48.60 for $4,860.  If shares of WMT dropped $10 to $38.60 and I decide to cover my short, I would buy back the 100 shares at $38.60 for $3,680 and sell my borrowed 100 shares at $48.60 back to my broker.  As a result, I have made a profit of $1,000 ($4,860 - $3,860).

Now let’s look at an example of people losing money by shorting stocks.  If I decided to short 100 shares of Johnson & Johnson (JNJ) today, I would be borrowing 100 shares at $56.55 for $5,655.  If shares of JNJ jumped $15 to $71.55 and, out of fear that it was headed even higher, I decide to cover my short, I would buy back the 100 shares at $71.55 for $7,155 and return my 100 shares at $56.55 to my broker.  As a result of this bad decision on my part to short JNJ, I have lost $1,500 ($7,155 - $5,655).

So why do investors occasionally decide to short a stock? The first reason is because they are speculating that the share price is on its way down.  Another reason investors short stocks is to hedge their investments.  Hedging is just another way of saying that an investor is attempting to limit his risk and limit his potential losses.  So, if an investor is long on a few stocks and short on a couple, he will limit his risk if the overall market goes down.  The problem with hedging, though, is that you also usually limit your potential gains as well when the market goes up. 

So, what makes shorting stocks so risky? First of all, history has shown that, over the long run, stocks usually have an upward trend and appreciate in price.  So, by shorting a stock, you are going against a historical trend in the market.  Another aspect of shorting that makes it very risky is the fact that your losses can be infinite and your gains are limited.  There is no limit to how high a stock’s share price can go, so you could potentially have huge (theoretically infinite) losses when shorting stocks. But, the best-case scenario for short sellers is if the stock price goes to zero, so the amount you can gain is limited.  On the other hand, if you are long on a stock there is a limit on the downside, as the worst-case scenario is that the share price goes to zero (but that is the lowest it can go).  But, investors who are long on a stock have unlimited potential gains, as the share price of their stock has no ceiling (it could theoretically keep trading up forever). 

Another risk that comes with selling short is the fact it involves using borrowed money.  Because you are using your broker’s money, your broker has the right to ask for his money back if your losses get out of hand.  This places many investors in dangerous positions, as they are forced to incur huge losses without the chance of making them up if the market begins to turn in their favor.  The fourth and scariest risk of short selling is the concept of the “short squeeze”.  A short squeeze occurs when a stock that many people expected to drop begins to rise.  Due to the rise in the stock price, many of the short sellers who were betting against it try to cover their positions and buy back their borrowed shares. With so many investors buying shares, the stock price can quickly jump to ridiculous levels.  If a short squeeze occurs and you are late to cover your short, you will be in a lot of pain, as you watch the stock you needed to go down continue to race to new highs.

Because of these risks, and because of its counter-intuitive nature, short selling is usually not advised as a trading strategy for novice investors.  As you learn more about shorting stocks and become more comfortable with market trends and analyzing individual stocks, hopefully you will one day take advantage of short selling to make some money!  Until then, keep reading College Trillionaires and keep learning!

 

Niki Pezeshki

College Trillionaire