An old man on his way home from work received a call from his wife who said, “Honey, please be careful driving. I just saw a news report that said there is someone driving the wrong way down the highway.”
The husband replied “Oh sweetie, you don’t know the half of it! There are hundreds of them!”
We have discussed what it means to buy a stock and own a stock. In market speak, buying a stock is called going long and owning a stock is called being long the stock. But you may have also heard the term being short stock, selling short, or being a short seller of shares. The short position is exactly the opposite of being long. You are betting that the price of the shares will fall rather than increase in value. Investors may make this negative bet against a stock if they do not like the company or its products, if they believe the company’s management or its financial statements are suspect, or if they feel that a company’s large debt load may hurt the company’s long-term prospects. There are many reasons an investor may want to bet against a company’s shares, but only one good way to do it: by shorting the stock.
What does it mean to short a stock? An investor will borrow stock from someone else and sell the shares into the market. He will later buy back shares in the market, hopefully at a lower price than he sold them for initially. That’s how he will replace the shares he borrowed and make a profit from the decline in the stock price.
As an example, let’s say a teenager’s parents went out of town for the weekend on Friday, and left their responsible son at home with Dad’s new car. Later that day, the doorbell rings.
At the door is a man who says, “Sorry to bother you, but I just love that Mercedes in the driveway, and I must buy it from you.”
The son thinks about the idea and replies, “Okay, fine. But I want $50,000.”
“Done” says the man, who immediately hands the cash to the boy, and drives off in the car.
The boy has sold something that he does not own, so he is now short one Mercedes. The industrious teen now really needs to find an exact replica of his dad’s car to replace it with, and he needs to do it by Sunday at 6:00 P.M. when his dad returns home. The teen searches all day Saturday, and locates the exact same model, and finds it a great price of $40,000. The teen buys the car, parks it in the driveway, and his dad is never the wiser. Since he bought the car for $40,000 and sold it for $50,000, the teen has profited by $10,000. He just did it in the reverse order of a typical purchase-and-sale transaction.
In the stock-investing world, a short investor will need to work with a brokerage firm to borrow shares that he does not own so that he may sell them short. When the brokerage firm locates shares, the investor will borrow the shares and sell them in the market. He is now short those shares and will have to buy the exact number of shares back at some point in the future. If he sells the shares for $50 a share, then he will need to buy back shares later at a price less than $50 to make a profit. The problem for the investor arises if the price of the shares increases. If the price of the shares rise to $60 a share, then the investor now has potential losses of $10 a share.
If the investor gets nervous and chooses to close out his position in the short at $60 a share, then he will have to pay $10 more a share than he sold the stock for initially. The stock price could even rise to $100 or $150 or higher. The investor would then lose a lot of money if he were forced to buy the stock at $100 after initially selling it for only $50. He would need to make up the loss by adding more money to his brokerage account.
A situation called a short squeeze is also a possible danger in shorting a stock. Going back to our example, let’s say the teen was unable to find an exact copy of his dad’s car at a reasonable price. And that three other neighborhood teens had also sold their dads’ cars short that weekend. It is now Sunday at 3:00 P.M. and all the boys start panicking. With such high demand for the same car, the price of the only cars available rise to $75,000 each. There are no other options as the dads are headed home soon. Our original teen is forced to borrow $25,000 from a friend. He combines that money with the $50,000 that he received on Friday so that he can buy the replacement car. Selling his dad’s car short was a terrible idea, the teen concludes.
For most investors, selling stock short is a bad idea. Buying stock to hold for the long-term is investing, but selling stock short that you may be forced to pay a much higher price for later on to replace the borrowed shares is gambling and is very risky. Historically, stock prices usually rise over time, so it is best to keep to the long side of the market. An investor does not want to be driving on the wrong side of the road on a one-way street.
