Confused about the profit generated from a short sale of shares

Factual Questions
1

Hi,
I usually think of making a profit when I own something that I have bought cheaply and sell at a higher price than I originally bought it for. I can’t see the connection with the following transaction. I don’t understand where the profit comes from. The broker borrows the stock for me to trade with using my margin account as collateral (correct?). So the price of a share goes down from $ 65 ( $6,500 for the shares. This is where I’m confused. I don’t own the stock. I’m just borrowing it to trade with right? The $6,500 is just collateral right?). So it goes to $40. Now I buy the shares for 4000. So 6,500-$4000= $2, 500 profit. The problem for me is I can’t see the profit here. I know I’m missing something in the equation. As I said I only see a profit if I have something to sell that I bought cheaply and sold at higher price. Confusing for me is going from $6,500 , buying back at $4000 and getting a profit. I suppose I’m thinking about buying shares for $4000 and selling them for $6,500. Then I see a profit of $2,500. Where am I making the mistake in my train of thought ?

I look forward to your feedback.
davidmich
see transaction below.

Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let’s take a look at how this transaction would unfold.

Step 1: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says “short sale” and “buy to cover.” In this case, you decide to put in your order to short 100 shares.
Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:
the brokerage firm’s own inventory
the margin account of one of the firm’s clients
another brokerage firm
Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

One of two things can happen in the coming months:
The Stock Price Sinks (stock goes to $40)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $2,500
The Stock Price Rises (stock goes to $90)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $90 -$9,000
Your Profit -$2,500

Clearly, short selling can be profitable. But then, there’s no guarantee that the price of a stock will go the way you expect it to (just as with buying long).

2

I think you’re overcomplicating things.

Forget about collateral. It’s irrelevant. You profit when you buy low and sell high. Short selling is no different; you’re just selling before you buy instead of the other way around. Borrowing the shares allows you to sell them before buying them. Then you buy them from the public market and give them back to the person you borrowed them from. If the price went down during that time, you made a profit. That’s all there is to it.

3

Is this some weird game where you post the answer to your own question in the first post in the thread? This is the answer.

4

Yeah.

By the way, a major difference between ordinary stock buying and short selling is the risk involved. If you buy a share at $40, the most you can lose is $40 (which happens if the stock price drops to zero). There’s no limit on how much you can make, however, if the stock price rises.

On the other hand, if you promise to sell a share of stock at $40, the most you can make is $40 (which happens if the price drops to zero), but there is no limit to how much you can lose, if the price rises.

5

However, the theoretical unlimited loss is mostly theoretical. In practice there is a limit as to the rate at which stocks go up. A company that does really well could see its price per share go from $10 to $20 or maybe even $50 or $100 in a year. It is extremely unlikely that such a stock would go up to ten trillion dollars per share in a short time absent extremely profound or catastrophic economic changes.

6

Agreed.

7

Is there a time limit to when you have to cover your short? What if you never close your position? Sorry for the stupid question, I guess I’ve just never thought too much about the mechanics of short selling beyond the borrow-and-sell, then buyback later.

8

In theory there is no time limit. It can happen, though, that the brokerage will force you to cover your short because it doesn’t have any more shares to borrow anymore. They can also force you to cover your short (basically do it for you) if your margin has risen above the limit that the brokerage has set.

9

For the OP:

Think of it this way.

You start with $0, and 0 stock.

You short sell 400 shares for $6500.

You now have $6500 and -400 shares.

You cover with 400 shares for $4000.

You now have $2500 and 0 shares.

That make sense?

10

It is worth distinguishing between a covered position and an uncovered (or naked) short.

What you’ve described is an uncovered position - meaning that you don’t own the stock and have an essentially unlimited risk.

A much safer bet (the covered option) is to sell shorts on stocks you already own. You often do this in the hope that you don’t have to sell the stock; you’re profiting by selling the short option and keeping that money when the stock value fails to go down enough to make it worth the option buyer’s money. (i.e. the short is for $30, but the price only goes down to $33. Thus, the option buyer chooses not to execute the option. Your profit is the price of selling the short, less commissions and fees.)

The safer option doesn’t get talked about as much… maybe because it’s mostly a way to eke an extra 1% or so in gains on your portfolio. Most people would rather fantasize about hitting the jackpot on an uncovered position, but it’s a pretty stupid way to invest.

11

dracoi,

You’re just confusing things here. No one was talking about trading options.

12

I want to make sure I understand this. I’ve sold 400 borrowed shares (at $65 a share ) for $6,500. That $6, 500 goes into my margin account. (-400 shares now). The stock price goes down to 40 share as hoped for. I buy them back at the lower price of 40 a share. They are then returned to the broker (correct?) I spent $4000. buying them back. The profit is $2, 500.
davidmich

13

The OP has gotten his answer. You make profit in the usual way: Buy Low; Sell High. The order of the two steps is merely reversed! :cool:

With OP answered, let me mention the similarity and difference between selling short and buying on margin. (In either case collateral is needed, but that’s irrelevant to the discussion.)

When you buy on margin, you borrow dollars and then trade them for shares. The shares are yours – you collect the dividends (and, in effect, capital gains if any) – but you must pay interest on the money you borrowed.

When you sell short, you borrow shares and then trade them for dollars. The dollars are yours, but you must pay dividends (and, in effect, eventually, capital gains if any) on the shares you borrowed. Although you may pay a fee to borrow the shares, you won’t pay interest on them because they weren’t earning interest for the borrowee. Shares pay dividends and you do pay those.

So you buy on margin when you think the shares will outperform interest-earning dollars and sell short when you think the opposite, right?

Wrong! Or rather, wrong unless you’re a big player.

If the interest rate is 5% you’ll make 3% on a margin-buy if the shares produce 8%. Or, a big player will make 3% if the shares produce 2%, underperforming dollars. But you can’t do that if you’re a little guy! That same short-sell that yields 2% for the big player is a 3% loss for an average little investor because the little guy is not paid interest on the cash proceeds from his short sales.

This may be unimportant with today’s very low interest rates, but is a huge difference with normal interest rates. This fact, not widely known to small investors, is a good reason to avoid short selling. (Do any brokers pay interest on such cash to average investors?)

14

Yep - well you get charged interest - but it won’t be much.

It is “easier” than you might think. You don’t really handle the loaning and borrowing of the shares. I haven’t shorted in a while, but there is basically an option on the pull down menu for trading stocks that reads “sell short”. You fill out the price, symbol, qty - just like you would for any other order. Then when you want to end it - there is another option for “buy to cover”. YOU don’t have to do any of the lending or borrowing - that all happens behind the scenes. It is really no more difficult or time consuming then regular buying/selling.

To address what someone asked about why can’t you do this forever…

You are charged interest. This is done in a Margin account and like all margin related transactions - there is an equity requirement. You usually can only have a minimum of 50% equity in your account.

In other words - if you open an eTrade account and send them a check for $50,000 - you will be allowed to buy $100k worth of stock (this is simplifying - and varies for some markets). If you then end up going below a certain amount - say 40% - you will get a “margin call” - this is a nice way of saying - hey - sell your stuff cause we want our money. Then the next day or so - they will sell it for you.

Something similar happens with shorting a stock. If you drop below a certain level of equity - they will “buy to cover” for you - possibly covering when you don’t want them to. So you have to make sure you understand the equity requirements. You might want to put up a lot more in equity just to prevent them from doing this.

Again - I didn’t feel like looking up all the current rules - so I am simplifying a bit.

15

Good point. I jumped to options without really thinking about it because options seem like the superior way to achieve what the OP was describing. But there is a difference. Since I don’t want to derail the thread any further, Investopediahas a good description of the differences between short-selling and put options, including a comparison the costs/risks/proceeds from an example.

16

Thank you all. Very helpful.
davidmich.

17

Just to add a (noobish) question to this topic - the motivations of the short seller are clear, but what about the entity who’s doing the initial share lending? Is there a transaction fee on the initial lending, and are there rules that dictate they must lend (a proportion) of their shares to someone if they ask?

I’m thinking of the situation where a large instituational investor, say a pension fund, receives a request from a short seller for some shares in a company they hold. Imagine 2 situations - first that there is there is trouble at mill with the company, so a lot of people want to take short positions. Second, things are tranquil and there are no obvious reasons for taking a short position.
In the first case, having the whole world short your stock sounds like a very bad situation. So why would the pension fund agree to lend any shares out in the first place, when the act of doing so could contribute to a significant erosion in their value?

18

You’re correct - there is an entire active market for the lending of shares. Lenders usually quote borrows a price either in cents per share per day or an interest rate. As the demand for short selling in a security goes up, the rate lenders charge borrowers goes up. It can be a not insignificant stream of income for institutions’ lending desks.

The whole system is pretty convoluted and opaque, though. Not every broker has relationships with other brokers lending securities that their customers are looking to borrow. There exist companies whose business it is to maintain relationships with lenders and act as a middleman for borrowers.

Example: http://www.stock-borrow.com/

19

My understanding was that, at least for “little guys” like myself, opening a margin account gives my broker the right to lend my shares to a short-seller with neither permission from, nor fee paid to, me.
(Perhaps I’m wrong?)

20

AFAIK, that’s correct.

The only retail broker I know of that provides any sort of benefit to the customer in this arena is Interactive Brokers. They will pay you interest on your short position if it is in excess of $100k US.

http://ibkb.interactivebrokers.com/article/41