One of the questions I’ve been getting lately is: how do I short a stock?
Before, I answer that question, I need to emphasize: shorting stocks is VERY risk, because there’s the risk of unlimited loss.
Before I answer the question, I first want to explain short selling.
If you’re a fan of the show Billions, on Showtime, there’s a good chance you’ve at least heard the phrase used before.
Here’s a quick primer on short selling:
When you believe a stock is going to rise in value, you will buy the stock (or call options) and someone might say you’re “long” or “bullish” on the future of the stock. Basically, you believe the stock is going to go up in value and you’re going to make money.
When you believe a stock is going to decline in value, you are said to be “short” or another way of saying it, you’re “bearish.”
Hence the age old struggle between the bulls and the bears.
Short selling is simply how you bet on the decline in a stocks value. But, it’s way less utilized by retail investors and not often fully understood.
You can be bearish either through buying put options or through shorting the stock. We’ll leave purchasing puts for another day, but I want to dive into the mechanics of short selling a stock with an example.
Imagine I read that weather is going to warm up significantly in Colorado next month and I believe this is going to lead to a huge surplus in ski supplies in the near future, leading to clearance sales on ski supplies. Warm slopes means less people skiing.
Like any good entrepreneur, I want to profit from the the warming weather. And, lucky for me, it so happens that my friend Michael recently moved to Colorado and just bought a bunch of ski gear that he isn’t going to use for a few months, so I convince him to let me borrow his gear.
But, then I pack his gear into my car and head to Vale for the weekend and start selling his gear to skiers in the village. Let’s imagine that things go well and I sell all of Michael’s brand new gear for $500.
I now have $500 in cash, but there’s a slight problem. I promised Michael I’d return his ski gear.
But, remember, I believe warm weather is just around the corner.
One month later, the temperature soars, nobody is coming to ski and stores starts putting ski gear on clearance. Now, I can buy the same ski gear I borrowed from Michael at a 50% discount.
Remember, I have $500 from selling the gear, but I’m able to repurchase the same ski gear for $250.
Like a good friend, I return Michael’s ski gear and give him $25 as interest for letting me borrow the gear.
I sold the equipment for $500 and then bought it back and returned it for $275 ($250 plus $25 in interest). Don’t tell Michael, but I made $225 profit on this “short” position!
Now, it could have gone the other way. If I had been wrong about the weather and the price of ski gear had risen, I would have had to “cover” the short by buying ski gear to return to Michael – no matter how much it costs. I would have lost money. Possibly a lot. Because the price of a short can rise infinitely and losses from short selling are uncapped.
So, back to our original question: how do I short a stock?
In the equities market, you don’t borrow stock from a friend, but instead your broker will “loan” you stock from another customer, if you have “margin trading” enabled on your account and if the stock is available (some stocks are much harder to borrow). Like Michael, the brokerage will charge you interest for the right to borrow the stock.
If the stock goes down in value, you can close your position at a profit. If the stock increases in value — then you can close at a loss.
But, “shorting” a stock is risky.
As I said out the outset, when shorting a stock there can be unlimited loss, so when a stock starts going up in price — it can lead shorts to start “covering” their position, which drives up the price. Supply and demand. But, the more people who cover, the faster the stock rises — causing a short squeeze and that just amplifies the pain, but that’s another post.