Normally a highly advanced topic which would require some prerequisite courses, recent events and a reader request have pushed Short Selling to the front of the College of Weakonomics agenda.
Short selling is the exact opposite of buying stock. You purchase stock because you expect the price to go up. Let’s say I buy Wachovia stock expecting the price to go from $10 to $20. That’s a good reason to buy, and if that happens I’ll make good money.
But what if I think the price is going to go down from $10 to $1? If I own the stock I would sell it. But wouldn’t it be cool if I could make money on this knowledge without owning the stock? It is cool.
There are two ways to make money on the expected reduction in the price of a security (a stock). Choice A is a Put Option, which is a subject for another day. Choice B is a short sale.
Getting back to our Wachovia example, I have a feeling the bank is in big trouble and will need a bailout (like what happened). I’m expecting the price to drop from $10 to $1 per share. I wouldn’t buy the stock, that would lead to a loss of $9. I’m going to contact my brokerage office and short Wachovia.
In essence, what I’m doing is borrowing someone else’s Wachovia stock and selling it. I’ve now sold the Wachovia stock for $10, because that is what it’s currently priced. I have that $10, but I have to buy back the Wachovia stock within a certain amount of time, let’s say 30 days for simplicity. Around day 15 the price tanks to $5 and by day 28 it hits the $1 mark I anticipated. With my $10, I now buy a share of Wachovia stock to give back to the brokerage house I borrowed it from. But I still have $9 left. That’s my money, and my profit. Excluding transaction costs I made $9 from nothing!
It seems simple but it’s a very risky game. I can think Wachovia stock is going to tank, but that doesn’t mean it will happen. What happens if the stock jumps up to $20 from $10? Well I have to still buy the stock back because it was borrowed, which means I lost out on $20. (Keep in mind you can’t do this game in single shares, you could lose thousands overnight).
Shorting is risky, but the potential returns are outstanding. This means there are people out there that will do it. There are ways to protect yourself if the stock goes up. There are some fairly complex formulas out there designed to protect yourself from losing too much, but they also limit your potential gains. It’s an effort to find a sweet spot and insure yourself. Let me illustrate and keep in mind this is a “High Level” Weakonomics course, so don’t give yourself a headache if you can’t follow. Read it again in a few weeks and I will probably make sense.
I’m an investor that has just seen the price of his stock in Google go from $400 to $500. My gain is $100. This was an unexpected rise in the price but I would like to protect my gains without selling the stock. So I short Google at $500. I borrowed the shares and sold at $500, if the price decreases back down to $400, I buy back the Google shares and make $100 on the short sale, all the while my original shares in Google are back to $400 (I don’t care because I still made $100 on the short, in essence, protecting my gains). Google might instead spike to $600 from $500, this means I now have to buy back to borrowed shares at $600. I have $500 from the sale so I need to produce $100 of my own money to cover the loss. No problem, the shares I own in Google also went up to $600 giving me a gain of $200 over my $400. Take $100 of that $200 to cover my $100 loss on the short and I’m still protecting my $100 gain. Insurance!
This process is known as “shorting against the box” and is one of many reasons someone might short a stock or any security. No I won’t explain what “shorting against the box” means. It protects my $100 gain no matter what, minus the costs of the transaction. When you take into account hedge fund managers do this with millions of dollars at a time, transaction costs are minimal.
What’s the Beef With Short Sellers?
Short sellers are frowned upon the same way we look down on a casket retailer that price gouges. They’re taking advantage someone else’s misfortune. It’s easy for the business media and traditional investors to bash the short sellers. Short sellers will buy the short, and then talk in forums and stock websites about how terrible the company is, thus driving the company down falsely. A hedge fund manager can introduce enough shorting into the market that he’ll actually drive the price down on his own. But the anti-short folks always ignore the fact that they can manipulate the price the same way. I can buy the stock and then talk about how great the company is in forums and websites. A hedge fund manager can buy so much stock in a company that he again drives up the price on his own.
The SEC temporarily banned shorting of various financial institutions because they prices of the companies had already suffered so much. The shorts played a big part in WaMu’s and Lehman’s failures. Too many people shorted the stocks anticipating the failure, that they may have actually created the failure. This is a self-fulfilling prophecy. Forcing a failure like that hurts the economy and costs the tax-payers money when a failure may not have happened without them. The SEC banned shorting because they didn’t want the shorts to needlessly “fail” other banks. It’s a complicated and controversial discussion, and I’m still unsure about how I feel about it.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
