If you’ve ever wondered what it means to short a stock, you’re not alone. It’s one of those quasi-arcane terms that investors have come up with to describe a crafty but relatively straightforward strategy for making a profit without laying out their own capital at the start of the process.
Let’s take a look at how short-selling works, and shed some light on what kinds of investors ought to be employing the method as part of their portfolio.
Short Selling Explained
One way to grasp the concepts that come with investing is to get out of the world of the abstract and into the world of the concrete. We’ll approach our questions about shorting stocks by thinking about a story that deals with the kind of things anyone can see and touch.
Let’s say you know this fellow who runs a commercial warehouse.
He does some distribution work, and gets a bit involved in importing and exporting. He’s a flexible sort. Sometimes he covers some of his customers’ up-front costs and they’ll leave with him some goods as collateral — and of course he charges a little interest — while they take care of business. (Think of this fellow as a stockbroker.)
Now, you might be a businessperson yourself. In our story, you move high-end video equipment around, buying and selling stuff like flat screens and Blu-Ray players, and so on. You’re not big time, but you make a living. (Think of your role, in this case, as that of an investor.)
So you get a tip from a friend that the price of last year’s super popular plasma screens is going to take a pretty serious dip when the next generation LCD hits the market. (Disclaimer: In reality, don’t follow anyone’s random hot tips! Do your research.)
The news hasn’t caused the plasma screens to stop selling like hotcakes yet, because not enough consumers know about the new model coming down the line. (The video equipment, in this case, would be the stocks.)
Problem is, you haven’t got the kind of cash on hand that would allow you to stock those new LCDs at their initial asking price. So, although you’ve got some good information, how are you going to make a buck?
One way might be to work with your friend in the warehouse. You’ll need a system.
Here’s how it works when that system is short-selling:
- Borrow: You know your warehouse guy has got about 100 of those plasma screens sitting out back, because he told you that one of his clients left them there as collateral last month. You make him an offer: you’ll sell the client’s plasma units right now, and then replace them next quarter by scooping up a fresh 100 units when the predicted price drop goes down.
- Sell: Your warehouse friend says he’ll put the plasmas on your truck, but he’s calling the loan of inventory a favor. In return for the favor, he wants one of the new LCDs to come back to him with the plasmas you’ll return to the warehouse. Deal. You go off and sell the screens for $1,000 a piece, for a total of $100,000.
- Rebuy, Replace, and Profit: Now, let’s say everything goes as predicted. The new LCDs come out. The price of last year’s plasma drops to $799 because consumers start buying the other model. Using the $100,000 you just made on the pre-drop sale, however, you spend $79,000 to buy 100 screens to return to your warehouse guy (and you pick him up one of the new and popular LCDs for about $2,000). In the end, you netted $77,000 and you didn’t spend a penny to get the process started.
So, to summarize all of this in a single statement, and in investing terms only: shorting a stock is when you borrow shares from a broker, sell them and then replace the shares you borrowed by buying them back at (hopefully) a lower price and keeping the difference.
When Short-Selling Goes Wrong
Our example is, of course, a little bit basic. It leaves out some nuances and it is predicated on everything going just right in stage three.
But what happens if the price of plasmas doesn’t drop? Or what if the warehouse client comes back for their collateral early; that is, before the new LCDs hit the market?
Point is, you can get burned if the timing or the turnout isn’t in your favor.
Short-selling can be a route to profit, but like any gamble you shouldn’t extend yourself beyond what you can afford to pay if you have to cover what you borrowed.
Now that you have an idea on what is short selling, take the Intro Course on Wall Street Survivor to get a deeper understanding of the risks and rewards of short selling.