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.
