What Does It Mean?
Shorting a stock, otherwise known as short-selling, is an intricate financial strategy practiced predominantly by investors and traders who hold a pessimistic outlook on a particular stock’s future performance. These investors predict a fall in the stock’s price, positioning themselves to potentially benefit from this anticipated downturn. It is a strategy that runs counter to the standard logic of investing, which typically encourages the purchase of assets with the expectation of a price increase.
When an investor shorts a stock, they’re making a bet that the price of that stock is going to go down. To make this bet, they need to sell the stock. But they don’t own the stock yet, so what they do is borrow the stock from someone else.
Let’s look at the borrowing part in more detail. Where do they get the shares to borrow? They get them from a brokerage firm. A brokerage firm is like a bank for stocks, where people buy, sell, and hold their stocks. Sometimes, the brokerage firm has its own collection of stocks, called an inventory. They can lend these stocks out to people who want to short sell.
Alternatively, the brokerage firm can borrow shares from the accounts of other clients who are not currently selling their shares. These are often clients who have what’s called a margin account. A margin account is a type of account where the brokerage lends the client money to buy more stocks, using the existing stocks in the client’s account as collateral. Because of the nature of this account, the brokerage firm can also lend out these stocks to other clients for short selling.
Sometimes, the brokerage doesn’t have the stocks that the investor wants to short sell. In this case, the brokerage firm can borrow stocks from another brokerage firm.
Now, when the investor borrows the stocks, they sign an agreement saying that they will return the same number of stocks back to the lender in the future. This is regardless of whether the price of the stock goes up or down in the meantime. This is important, because if the price of the stock goes up (which is bad for someone who is short selling), they would have to buy the stock at the higher price to return it to the lender.
Once an investor has borrowed the shares from the brokerage firm, the next step is to sell those shares on the stock market. It might seem strange that the investor is selling the shares as soon as they’ve borrowed them, rather than holding onto them in anticipation of their value rising.
This is because shorting a stock involves a different strategy from the traditional approach to investing. Usually, the idea is to buy a stock at a low price, wait for its price to go up, and then sell it at this higher price, making a profit from the difference. This strategy is based on the concept of “buy low, sell high.”
But in short selling, the investor is predicting that the stock price will go down. So, they want to sell the stock immediately while its price is still high. This locks in that high selling price for them. If their prediction is correct and the stock price does go down, they can buy the stock back at this lower price. The difference between the high price at which they sold the stock and the lower price at which they bought it back is their profit.
Take A Look At This Example
Think of it like selling a borrowed bicycle for $100, predicting that the price of bicycles will drop in the near future. If you’re correct and the price does drop to $70, you can buy a bicycle at this cheaper price to give back to the person you borrowed it from. You would make a profit of $30 from this transaction. That’s essentially how short selling stocks works. But remember, if the price of the bicycle went up to $120, you would have to buy it at that higher price, meaning you would lose money. The same risk applies when short selling stocks.
After the investor has borrowed and sold the shares, they enter a period of waiting. This waiting period is critical to their investment strategy. What they’re hoping for during this time is for the price of the stock to decrease. This is the opposite of what most investors hope for; most people want the stocks they own to increase in value. However, remember that the short-seller has bet against the stock, predicting it will fall in price.
If their prediction turns out to be correct and the price of the stock does drop, the short-seller can then move onto the next step of their plan. They need to buy back the same number of shares they initially borrowed. However, because the price has dropped, they can buy these shares for less than what they sold them for.
To give a clearer example, let’s imagine the short-seller borrowed and sold 100 shares of a company at $10 each. They received $1000 from this sale. If the stock price drops to $7 per share, they can buy 100 shares back for only $700.
This price difference between the selling price and the lower buying price is where the short-seller makes their money. In our example, the short-seller would have a gross profit of $300 – they received $1000 when they sold the shares, and then only had to spend $700 to buy them back.
This gross profit doesn’t take into account any fees or costs associated with borrowing the shares or any interest that might have been charged. After subtracting these costs, the short-seller would be left with their net profit. But the principle remains the same: short-sellers make money when the price of the stock they’ve bet against goes down.
In the world of investing, there are often fees or costs associated with making transactions. In the case of short-selling, these might include fees charged by the broker for lending the shares to the investor, as well as any interest that might accrue on those borrowed shares over time. The broker provides a service (lending the shares), and they typically charge for this service.
When we talk about “net profit”, we’re referring to the total amount of money the investor gets to keep after all costs have been taken into account. In this scenario, these costs would include the broker’s fees and interest.
So, let’s say the investor successfully shorts a stock: they borrow and sell shares at a high price, then buy them back at a lower price, and their gross profit (before costs) is $500. But if they’ve had to pay $200 in broker fees and interest, their net profit will only be $300. Those fees and interest have “eaten into” their profit, reducing the amount of money they get to keep.
The investor needs to ensure the decrease in the stock’s price is not just accurate, but substantial. This means the price drop needs to be significant enough that even after paying the broker’s fees and any interest, there’s still a good amount of profit left over.
In other words, if you’re going to short a stock, you don’t just want the price to drop a tiny bit. You want it to drop a lot, to ensure that you can cover your costs and still make a good return on your investment. In our earlier example, if the price drop only allowed for a gross profit of $200, after fees and interest, the investor might not have any profit left at all.
That’s why short selling is considered high risk and requires careful consideration and market knowledge. It’s not just about correctly predicting a price drop, it’s about predicting a substantial enough price drop to cover the costs associated and still leave you with a satisfactory profit.
Short-selling, the practice of borrowing and selling shares in anticipation of a price drop, carries substantial risk. One of the most significant risks is the possibility that the stock’s price does not fall as predicted but instead rises.
In this scenario, the investor is in a difficult position. Remember, they’ve borrowed shares and sold them, and they are obligated to return the same number of shares. If the price of the stock goes up, they’ll need to buy back the shares at that higher price to fulfill their obligation. This results in a financial loss.
For example, if an investor borrowed and sold a stock at $20 per share and the price rose to $30 when they had to buy the shares back, they would lose $10 per share. The more the price rises, the bigger the potential loss. In theory, a stock’s price could go up indefinitely, meaning the potential loss from short-selling could be limitless.
On the flip side, the maximum potential gain from short selling is capped. The best-case scenario for a short-seller is that the price of the stock drops to zero after they’ve sold it. In this case, they could buy back the shares for nothing, and their profit would be the price at which they initially sold the stock. However, it’s highly unlikely for a stock’s price to fall all the way to zero.
Given these risks – the unlimited potential loss if the price rises, and the capped potential gain if the price falls – short-selling is generally done by experienced investors or traders. These individuals typically have a strong understanding of how the stock market works and are financially prepared to handle the potential losses that can come from short-selling.
Real Life Example:
To illustrate this, consider the real-life example of short-selling during the 2008 financial crisis. A notable figure, John Paulson, and his hedge fund Paulson & Co., shorted the subprime mortgage market. He predicted that the housing bubble would burst and that securities backed by subprime mortgages would drastically drop in value. To capitalize on this, he used financial instruments known as credit default swaps to effectively short the market. When the bubble burst, the value of these securities plunged, and Paulson’s bets paid off. He profited enormously from the downturn, with his fund reportedly making billions of dollars. However, it’s important to note that while Paulson’s bet was spectacularly successful, the risks involved were tremendous, and if the housing market had not crashed as predicted, the losses could have been catastrophic. Therefore, while the concept of short-selling can sound appealing, particularly in a bear market, the potential risks are substantial and should not be overlooked.
John Paulson is a famous investor who made a significant profit by predicting the 2008 financial crisis. He believed that the housing market, which was doing incredibly well at the time, was a bubble that would soon burst. This means he thought housing prices were much higher than they should be and were going to crash dramatically.
Securities backed by subprime mortgages were a big part of this housing bubble. Subprime mortgages are loans given to people who are considered high risk for a loan, often because they have low credit scores. These loans were packaged into securities that investors could buy and sell.
Paulson predicted that when the housing bubble burst, these securities would become almost worthless as many high-risk borrowers would default on their loans, causing a huge loss for those who had invested in these securities.
To make money from this prediction, Paulson used a financial tool called a credit default swap, which works somewhat like an insurance policy. In essence, Paulson bet against these subprime securities, predicting that they would lose value. He paid a premium to enter into these swaps, just like you would pay an insurance premium, and if his prediction came true and the securities defaulted, the other party to the swap would have to pay him a large sum of money.
And that’s exactly what happened. When the housing bubble burst, the value of these subprime mortgage-backed securities dropped significantly as many borrowers defaulted on their loans. Because of his credit default swaps, Paulson’s hedge fund made a substantial profit, reportedly in the billions of dollars.
However, this strategy came with a huge risk. If Paulson had been wrong and the housing bubble had not burst when he predicted, he could have lost a tremendous amount of money. The premium he paid for the credit default swaps would have been wasted, and if he had shorted any securities (borrowed and sold them with the intention of buying them back cheaper), he would have had to buy them back at a higher price, causing a significant loss.
This is a clear example of the potential rewards and risks of short-selling. While Paulson profited enormously from his successful bet, an unsuccessful short can lead to catastrophic losses. So, while the idea of making money from a market downturn can be appealing, it’s crucial to understand and be prepared for the substantial risks involved.
