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I own 10 shares of
company ABC at $50 per share. You believe the stock price of ABC
is grossly overvalued and is going to crash sometime soon. You
are so convinced that the stock will crash, you come to me, and
ask to borrow my ten shares of ABC and sell them at the current
market price for $50. I agree to lend you my shares as long as
you pay me back ten shares of ABC at some point in the future.
You take the ten borrowed shares, sell them for $500 and pocket
the money (10 shares x $50 per share = $500).
The following week,
the price of ABC stock falls to $20 per share. You call your
broker and tell him to buy 10 shares of ABC stock, at the new
price of $20 per share. You pay him the $200 (10 shares x $20
per share = $200). A few days later, you pick up the shares of
ABC and bring them by my office. "Here are the ten shares I
borrowed," you say as you put them on my desk.
Do you see what
happened? You borrowed my shares of ABC, sold them for $500. The
following week, when ABC fell to $20 per share, you repurchased
those ten shares for $200 and gave them back to me. In the mean
time, you pocketed the difference of $300.
The Speculative
Nature of Shorting Stock
What if the price of
ABC stock had risen? The person shorting stock would have had to
buy back the shares at the new, higher price, and absorb the
loss personally. Unlike regular investing where your losses are
limited to the amount of capital you invest (e.g., if you invest
$100, you cannot lose more than the $100), shorting stock has
no limit to the amount you might ultimately lose. Famed
investor Ben Graham told us there is nothing stopping an
overpriced stock from becoming more overpriced. In the unlikely
event the stock had shot up to $1,000 (which actually happened
to shares of Northern Pacific during a short squeeze in 1902),
you would have had to purchase ten shares at $1,000 a share for
$10,000. Taking into account the $500 you received from selling
the shares earlier, you would have lost $9,500 on a $500
investment.
In order to begin
shorting stock, you must open a margin account with your
brokerage firm. You will be charged interest on the borrowed
funds as well as subject to several rules and regulations that
govern shorting stock (for example, you cannot short a penny
stock, and before you can begin shorting a stock, the last trade
must be an uptick or zero-plus tick.) After taking these factors
into consideration, you will, hopefully, realize shorting stock
is not a financially fattening activity in most cases and comes
along with additional risks.
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