So how can someone sell stock that they don’t already have? To explain how shorting is possible, it’s important to review how a company’s stock is distributed in the market. Just as any “long” investor may hold shares of several stocks in his/her account, so might an institution (e.g.,, a bank or brokerage) hold shares of several stocks in its account. And in much the same way that a bank might profit from lending money, they are also able to profit from lending shares of stock.
If an individual thinks the price of a stock will go down, he/she essentially thinks that the current price of the stock is a good price at which to sell. That person would ask to borrow a certain number of shares from a bank to sell immediately. Once the stock is sold, the borrower still has the obligation to return the shares to the bank. That means the borrower will have to eventually buy the stock back on the stock market at a later date – also known as “buying to cover” or “covering a short position”. However, in order to make a profit, the borrower wants to buy the stock at a lower price than the price at which they originally sold the stock. The concept of shorting stock remains to buy low and sell high, however, shorting a stock requires you to perform these two steps in reverse order than when making “long” investments.
A sample short transaction would look like the following: An investor would borrow 100 shares of a stock currently trading at $10 per share, and immediately sell those shares for a total of $1000. The proceeds from the sale would be frozen in that investor’s account to cover the total needed to eventually buy the stock back. Several days later, the stock falls to $8 per share, and the investor covers his short position by buying back 100 shares. He buys those shares for $800 and returns them to the lender. The investor earns the difference between the original sale of $1000 and the subsequent cover of $800, for a total profit of $200.
The bank’s incentive to loan someone stock is that they can charge an interest fee on the value of the sale proceeds generated on the stock they lend. Plus, they know that they’ll get the stock back in the future, a fact which limits their own portfolio risk: Banks know that they will be better off lending than not, because regardless of the direction of the stock’s price movement, they will have the same amount of stock, but will also have the added interest income associated with lending the stock.
Though shorting is often used to mitigate risk associated with investing in the stock market, it is important to realize the concept of “unlimited losses” that are possible with short investments. When one makes a long investment, the most he/she can lose is the total value of that investment. So if the investment was a purchase of 100 shares of a stock that costs $10 per share, and the stock later falls to a price of $0 per share, the total loss (or maximum loss) for the investor is $1000. However, if an investor were to short the stock at $10 per share, and the stock were to rise, the losses for the investor would be theoretically unlimited (because the stock price has no upper limit). For example, say the stock rises to $40 per share – one would need to spend $4000 to cover the original short position, for a loss of $3000. And if the stock rose to $100 per share, covering the position would now cost $10,000 for a loss of $9000. As you can see, there is no limit to how high the price can go, and therefore, how much money an investor could lose. It’s this potential risk of unlimited losses that requires an investor to be vigilant when shorting in the stock market.
Over the long-term, the stock market in general is expected to gain about 12% on average per year. This fact makes shorting look like a bad idea in general, as it seems as though the general market is bound to move higher, or against the wishes of a short-seller. However, in the short-term, the market does fall in value, and on an individual basis there will always be stocks that perform poorly. It is when observing these select opportunities where short-selling can make sense as an investment strategy.
Shorting can be used as an effective portfolio hedge, helping to eliminate some risk associated with long investments in the stock market. But due to the possibility for unlimited losses, it should be something that is practiced before being put to practical use with real money. As we like to say at Marketocracy, failing to practice investment strategies before testing them with real money is about as potentially disastrous as failing to train in a flight simulator before taking your first flight.
Market Trend Signal™ trend following stocks trading system
Jesse Webb
Market Trend Signal™
Trend Following Stocks – Stock Ratings – Market Timing
