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What is Short Selling?

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What happens when a stock goes down? If you own it, you lose money on paper. Yet many investors have made money—real money, not just paper gains—in this situation. While you can't predict the direction of the stock market as a whole or any one stock far in the future, sometimes there are signs you just can't ignore.

As you might expect, Wall Street is more than happy to help you use techniques that may let you make a lot of money—or lose it all.

What is Shorting?

Shorting, or short selling, is the practice of borrowing shares of a stock to sell, with a promise to buy replacements to return to the lender in the future.

You may hear this referred to as "going short" or "shorting a stock" or merely "shorting". Essentially this is making a bet that the value of the security (the stock) will decrease. This is in opposition to buying and holding a stock, also referred to as "going long" or being "long on (the stock)".

It's important to know this shorthand, because any legitimate and ethical investment advice will include a disclaimer that the author is long or short on any specific stocks. (The most ethical advice from reputable organizations will require the author to have no personal position on the stock, but the presence of any disclaimer is a worthwhile sign of trustworthiness.)

How does Shorting a Stock Work?

Institutional investors, large traders, even (and sometimes especially) hedge funds have their own techniques to manage shorts. Michael Lewis's entertaining and mostly accurate The Big Short walks through shorting similar securities—in this case, mortgage-backed bonds.

For an individual investor, shorting a stock works like this.

You sign up to be able to short with your online broker. You may have to sign some papers or agree to a special arrangement, as your broker wants you to acknowledge that you understand the risks.

You pick the stock to short, and then you borrow it from your broker and sell it. Behind the scenes, your broker probably borrows it on your behalf, marks that you will need to cover the short, and deposits the sales amount less commissions into your account.

At some point in the future, you purchase the stock to cover the borrow. Ideally this on your schedule, but perhaps it's on the broker's. If you were right and the costs have dropped, you'll purchase the same number of shares at a lesser price and enjoy your profits. If you were wrong, you'll have to purchase the same number of shares at a higher price and take a loss.

How does that really work? Your broker keeps track of who owns what. As long as the accounts balance up and eventually reconcile in actuality, everything works out okay. You will have to buy back the stocks you borrowed though.

How does your broker make money on your short selling? Commissions, of course!

Risks of Short Selling

There's one risk of shorting, but it's a doozy.

Suppose you buy $10,000 of Facebook stock, because you believe that VR and the Oculus Rift are the next big thing. Your risk for going long on FB is that the company will go bankrupt and the stock will be worth nothing. The maximum you will lose in that case is the $10,000 you spent on the stock. (There's an opportunity cost, but ignore that for now.)

Suppose instead you think "Wow, VR is the next big thing, like it has been every 10 years for the past 50 years" and you short Facebook. You short 100 shares at $100 apiece, getting $10,000 in your account and you have the obligation to buy back 100 shares at the market price some time in the future.

If VR does take off, or Facebook continues to make money and the stock price increases, you'll lose money. Unfortunately, there's no cap on the amount of money you could lose. If you have to buy back FB at a market price of $1000 per share, you'll lose $900 per share or $90,000. If FB goes to $10,000 per share.... and so on.

In one sense, you're betting against the trend of the market. Good businesses make money, and over time great businesses succeed. On the other hand, the market sometimes does get overvalued. Some businesses are cyclical. Some businesses have fraud or structural problems, and if you can find these and take advantage of them, you can make money from shorting them.

As is probably obvious, shorting a stock that goes bankrupt is profit for you. Lots of profit.

Is Shorting Wrong?

Isn't this gambling? Instead of acting like an owner, aren't you betting against a company, taking money from investors who want to buy and selling it back to them when they're taking their losses?

That's one way to look at it, but it's an oversimplification. There are a lot of buyers and sellers, and you shouldn't assume that every transaction you make is perfectly symmetric. Someone might sell for a lot of reasons, including locking in tax losses at the end of the year or because they've held the stock for many years and want to take their profit now.

Short sellers provide the benefit of liquidity to the market. Even if no one who's long on a stock wants to sell it, people who want to short it can facilitate transactions by being in the middle. (That's why you'll probably have to buy back the stocks you shorted much sooner than you might initially think.) Of course this also increases the complexity of your broker's accounts, but they'll charge you a commission and it all works out.

Should You Short Stocks?

Shorting does seem to be against the spirit of value investing, especially the principles of looking for undervalued stocks and holding them for a long period of time. Shorting involves a lot more market movement and more rapid trades than value investors may want to do.

Of course, the process of looking for undervalued stocks can help identify overvalued stocks. Some of the same skills for finding great stocks to buy can help you find terrible stocks which could be good candidates for shorting.

You can make money shorting stocks and you can lose money shorting stocks. Your losses aren't capped the way they are when you go long. This risk is enough to keep many investors away from shorts, which is fine. You know your tolerance for risk and can manage that on your own. Whatever you do, stick to the guideline of understanding what you buy and why and the consequences of your decision. You'll be better off that way, even if you leave potential profit on the table. It's more important to sleep peacefully than to extract every penny from every opportunity you find.