Is this a reasonable description of how shorting stocks works?

Factual Questions
1

So last night, a friend of my husband’s came over for dinner. This friend is smart but occasionally a blowhard. In the course of dinner chat, he started describing how “those guys who short stocks are making money hand over fist.” Shorting stocks is not something my husband or I have ever thought about or understood before, so we asked the friend to explain. His explanation did not make much sense to us (I think he wasn’t really sure how it works himself).

Today, I looked at some stuff online, and I think I understand the basics now. I think the friend was explaining accurately but incompletely. I’ve whipped up a few paragraphs expanding on it and am about to share it with my husband, but I thought I’d ask the SDMB first: do I have this right?, given it’s a massive oversimplification?

Note: I’m not necessarily asking for opinions about how to explain this concept (or I’d’ve put it in IMHO). I’m asking whether I have the facts right.

OK. Here it is.

[QUOTE=emmaliminal]

Shorting stocks, simplified description

Owen the Owner owns 10 shares of ABC stock. On this day, ABC stock is going for $2 per share on the open market.
Bob the Borrower wants to borrow 10 shares of ABC stock from Owen. (Bob believes the stock price will go down.)
Owen agrees to this. (Owen believes the stock price will go up.) He loans 10 shares of ABC to Bob.
Bob gives Owen some collateral worth (at least) as much as the stock’s value at that moment—it’s going for $2 per share today, so Bob gives Owen $20 worth of collateral. They agree that Bob can borrow the stock for a week. They sign some papers.

When this the week is up, Bob will give 10 shares of ABC stock to Owen, and Owen will return to Bob the $20 worth of collateral.

While Bob has the stock, he sells it on the open market. (Yes, this means he sells something he does not technically own. This is legal because of the papers he signed.) He sells it for $2 per share, or $20. Those particular 10 shares of ABC stock are gone, out into the marketplace.

At this point, Bob is at risk: he is obligated to give Owen 10 shares of ABC stock at the end of the week, but he doesn’t actually have any ABC stock. He will need to buy some.

But Bob is lucky. During the week, the price of ABC stock goes down to $1 per share. From the open market, Bob buys 10 shares of ABC at $1 each, or $10.

Bob gives these new 10 shares of ABC to Owen, and chuckles happily to himself. He made $10 on the deal!

Owen returns Bob’s $20 worth of collateral, and grumbles irritably to himself. He hasn’t lost anything he wouldn’t have lost without the loan to Bob, unless he had sold the stock himself during the week. But since he thought the stock would go up, he wasn’t about to sell it anyway. If he sells that stock immediately when Bob gives it to him, he will have lost $10.

Where did the $10 Bob made come from? Indirectly, you could say it came from Owen, but it went through the open market first. This is (I think) the hardest part to wrap your head around.

**
Where brokers come in**

Like a real estate agent, Bronwyn the Broker helps Owen and Bob find each other, and makes it easy for them to do swaps. She handles the transactions and the paperwork. She gets a fee for her service. The fee might be a set amount, or it might be based on the value of the stock—it’s up to the broker to set which way her fees are based, and up to Owen and Bob to decide whether to use her services and accept her fee structure, or to go to some other broker.

[/QUOTE]

2

It’ll do :slight_smile:

3

okay, now I’m confused…
from your example, it’s easy to see how Bob took a gamble and made a profit.
But what was in it for Owen the owner? Why does he want to participate in this game?

He gives away 10 certificates of stock worth $20, he puts $20 of Bob’s collateral into his pocket,( which he doesn’t need–he could have just held the stock certificates), and at the end of the week, he gets back the same 10 pieces of paper that he started with. If the paper is worth a lot more, or a lot less, it doesnt make any difference…He hasn’t done anything with the paper. It seems like the only thing that Owen the owner does is lose control over his own possessions, while Bob uses Owen’s paper to gamble.

What am I not understanding here?

(please use words of one syllable–my understanding of high finance is zero.)

4

chappachula, I think Owen gets the right to do things (including “gamble,” as much as Bob is “gambling” with the ABC stock) with Bob’s collateral while he has it. If Owen’s convinced the ABC stock will only go up in value, he’d rather play with something else than it while he waits.

Right?

5

I believe what is missing is that Bob has to pay interest on the stock loan regardless of the outcome. If Owen was making the loan directly he would make money in the same way your bank makes money by providing you with a mortgage. Normally it is the broker making this money, not an individual.

6

One difference is that the short is open ended; you can remain short as long as you keep up on the margin. (IIRC, there are no interest charges).

Also, in general, you are borrowing the stock from the brokerage, not Owen. Owen can sell his stock at any time, even without you selling it back to him.

A better description is:

Bob thinks World Wide Widgets, currently at $30, will lose value now that J. Pierpont Finch is Chairman of the Board. He goes to his broker and borrows 100 shares of WWW. He pays his broker a fee to keep up with the margin requirements (which limits on how much you can borrow). Bob then sells the shares and is credited with $3000 in his brokerage account; at the same time, he owes the shares to the broker.

Bob waits. WWW does indeed drop to $15 a share. Bob buys the shares, taking $1500 from his brokerage account. He returns the shares to his broker, ending that debt. Bob made $3000 on the initial sale, then paid $1500 to replace the stock, leaving him with a $1500 profit (not counting fees).

But if Finch turns out to be a first-class chairman and WWW sales skyrocket. The brokerage insists that Bob pays additional money to meet margin requirements. As the stock goes up further, Bob keeps losing more money to the margin until he finally cannot (or decides not to meet) the margin call. The brokerage will then then Bob’s money and buy stock at the going price to close out his position.

7

There’s another sort of short: shorting your own stocks. Say you get given 100,000 shares valued at £1 but can’t sell them for 6 months. Now, in the U.K., at least, you get taxed on the value they were when they were given to you, so to protect yourself against the price tanking, you short them, agreeing to have the option of selling the shares in 6 months for a certain value. If the share price tanks, you exercise your option and sell the shares at the pre-agreed price.

8

Lost me there. Can you explain margins, margin requirements, margin calls, etc., for beginners?

9

As you state, the shares come from a margin account for which you pay interest in the form of the broker’s call rate. Generally because the time-frames are so short, the interest paid is insignificant to the other sums involved. To an individual the would be meaningless, but to an institution it can be the difference between profit and loss.

10

Margin is a loan from the brokerage or holding bank or other similar entity secured by your existing holdings or other collateral they deem acceptable. Brokerages will have different maintenance requirements. I.e. Scottrade requires 40% for stocks greater than $12.50, $5 per share for stocks $5-$12.49, and 2.50 per share for stocks .01 to $4.99. This means you have to have enough cash on hand to buy back those shares you shorted at any given time. Valuations will be calculated nightly after the market closes.

A margin call is a demand from the brokerage to settle your margin account. This can come in the form of additional funds deposited into your account by way of wire or cashier’s check, or the brokerage may sell any or all of the stock in the brokerage account at market prices to satisfy the shortfall. Brokerages will generally make the call while you still have the assets available.

You will pay interest on margin, currently Scottrade charges me 7.25% for margin.

11

The description in the OP is essentially accurate, as far as it goes, but describes only one kind of short sale. A short seller may not even have an opinion as to whether a stock is likely to go up or down, but instead may be hedging another position, engaging in arbitrage, or locking in gain.

The description of the borrowed security is not quite right. Generally the short seller simply borrows from a broker-dealer. The broker-dealer may supply the security from its own portfolio holdings, but more typically the security is borrowed from an institutional investor, which engages in securities lending for compensation, or from a margin customer, who agreed to allow his securities to be lent out in his margin agreement.

In the scenario described in the OP, the short seller’s gain was funded by the purchasers of the security that was sold short. They paid $2 for a stock that was worth only $1.

12

Is your friend perhaps living in 2007?

Perhaps someone with more knowledge knows better, but my understanding is that a big part of the economic downturn was short sellers getting caught with their pants down. The problem with shorting is that, while you can make a lot of dough in bad conditions, your losses are theoretically infinite. When you buy stocks, the most you can lose is what you paid – if the stocks are worthless. OTOH, when you sell short, a big increase in value in the underlying security means you could not only lose the value you invested, but even more.

–Cliffy