Shorting Stocks
The how and why of short positions
You 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 (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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