Short selling stock

How does this work? So you borrow stock from someone and then you sell it and then you pay . . . oh hell, I can’t understand it.

Can someone knowledgeable explain it to me, and explain as you would to a child.

Basically, you make an agreement with somebody to sell them stock in the future for a pre-determined price(usually the current price of the stock). If, on the date you have to deliver, the stock is worth less than that price, you’ve just made a profit(because you buy it for the lower market price and immediately sell it for the higher pre-determined price)

It’s basically a bet that a stock is going to decrease in value. It’s a very dangerous move, though, because if the stock goes up, you lose money, and the higher the stock goes, the more you lose. As the price of a stock can go to any height, you could end up losing any amount of money.

This is not correct at all. To short stock, you borrow it from someone (generally a broker). You then sell the stock the normal way in the market. The person to whom you are selling it, does not know you are shorting it (or doesn’t need to).

To close the short and make your profit or lose, you later purchase the stock (it need not be from the same person to whom you sold it) and deliver the stock back to whom you borrowed it from.

So basically shorting just reverses the normal ordering of purchase and sale.

What Rysto is talking about are options. They can work similarly to shorting stock, but are much more complicated.

Shorting stock also entails paying interest to the brokerage for borrowing the stock, so if the stock doesn’t go down fast enough, those fee will eat into your profits.

OK. So an example then: I approach a broker and borrow 100 shares of HP (at $32) and I immediately sell it for $3,200. Six months later the stock has dropped to $24.50 so I buy back the shares at $2,450, return the stock to the broker and smile with my $750 profit.

So when I borrow the stock from the broker I assume that terms are set up at that time as to when I must return the shares to them? I would also assume that they asses some service fees as well?

You’d think so, wouldn’t you? But in my experience, it’s transparent and ends up exactly like a normal buy/sell. There is no deadline and there are no fees.

Note that there are a lot of caveats to short selling.

First, You DO have to give back the shares eventually, and if the stock has risen, you’re going to do so at a loss (although see below). Given enough time, most stocks rise in value, so short selling is usually a short-term behavior. No stock can go below zero, but they can rise more or less indefinitely, so there’s definite risk here.

Second, the broker won’t let you borrow or hold borrowed shares indefinitely. Policies differ based on your broker, but in general they start insisting on getting their shares back when the amount you owe them (in dollars) exceeds some percentage of the amount you have invested with them. (They always have the recourse to force-sell your other securities in order to pay.) This is called a margin call. A caveat to this is that you generally can’t just open an account and start short-selling; you’ve got to have some assets in the account first.

Last, at least some brokers won’t let you short (or buy options) on accounts that are IRA-like (intended to be retirement funds). I don’t know if this is a federal rule or just a risk-reduction rule by some brokers.

Options are similar in some respect, except that you offer to buy or sell on a specific date, for a specific price. For this privilege, you pay (or are paid, in the case of a sell) a small percentage of the stock price. The buyer is NOT required to actually make the purchase, in which case all they’re out is the fee. This can be used as a form of “insurance” when short-selling:

Imagine you think the stock FOO (currently $100/share) will go down soon. You “borrow” 100 shares of FOO from your broker and (short) sell them. At the same time, you buy an option for 100 shares of FOO at the current price (for which you pay a small fee). You’re hoping that the price will decrease, at which point you buy back your shares at a tidy profit, give the shares back to the broker, and just let the option expire. You’ve reduced your profit by the option fee, which is a bummer, but imagine the other case:

FOO is bought out by a larger competitor, and their shares rise 1000% percent overnight. If you hadn’t bought the options, you’d be in a pickle–you owe your broker $100,000 worth of a stock that you sold for $10,000. Luckily, you bought that option: you can still buy FOO at $10/share. You do so, and pay back your loan. You end up down whatever the option fee was, but you COULD have been down $90,000.

That’s interesting about the options to protect yourself if the stock rises - I knew about them, but hadn’t heard of them used together with short selling. Any idea how much an option fee is? Will every short seller always use them?

Well, most people probably should cover their shorts with options. But shorts are very simple to trade even if you don’t understand how they work (just negative from normal trading), whereas options are complicated and use different terminology. Also, your average margin account doesn’t have option trading ability unless you add it. So I doubt most people actually do it. And then they lose big when they bet wrong.

Also, I want to point out dilemma people run into with short selling…

You are confident a stock a stock is overvalued, and that the price will drop in the future. So you sell some shares short. And it does go down. Woo! But before it goes down, it goes up some more, and you get hit with a margin call and have to buy to cover at a loss. Even though you bet right in the end, you still got screwed.

This is straying into IMHO territory, but there really isn’t any justification for the “regular guy” to be shorting stocks. Shorts can be useful as part of a hedging scheme, but you are betting against capital appreciation, which is kind of like betting against the Globetrotters.

He who shorts a stock thinking he knows something the market doesn’t is delusional or trading on inside information.

Another complication with short selling is dividends. Many large companies pay a small amount of cash to all of their stockholders every three months or so. When you short sell a stock, you become responsible for paying those dividends. For example, Caterpillar will pay you $.48 for every share of stock you own. If you own 100 shares, you receive $48.00. If you’ve shorted 100 shares, you are listed as the owner of -100 shares and so have a dividend of -$48.00. That money will be taken from your account and paid to the investors that you borrowed the shares from.

Again going into IMHO territory, but for the average investor, the greatest importance of knowing about short selling is that it explains the ending of Trading Places.

Investopedia is a good site.

Selling short:
The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.”

You can buy a stock if you think the price will rise. You can “sell short” if you believe that it will fall.

A futures contract is a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.

That sounds like the animal that Rysto described.

An option is a security giving the buyer the right, but not the obligation of buying or selling a security or commodity in the future. That’s a third type of financial instrument.

There are fees specific to shorting. When borrowing stock, as when borrowing cash, you will be charged interest on the value of the stock. On the other side, the lender earns interest for lending stock, and the broker makes money on what it charges the borrower and pays the lender.

In addition to the potential for unlimited losses (unlikely, as the first time you miss a margin call*, your position will likely be covered regardless of your wishes), there is the potential for the pool of stock loaned to dry up and for your short to be called. For example, when a short seller asks to borrow stock from the broker (let’s use Goldman Sachs - GS), GS looks into its inventory of stock available to lend. Much of this inventory is provided by owners of the security who have agreed to lend their securities. If the owners decide that they no longer want to own the security, then GS is obligated to call in the loans, and the short seller will have cover his position.

*Margin call - short sellers are required to keep an amount of cash or treasuries (maintenance requirement) on hand for short positions to mitigate the risk to the broker. Using neorxnawange’s example, if he shorted 100 HP @ $32, he does not have $3,200 to spend. If the stock starts rising, say to $35, he will be required to deposit more $$. If the stock falls to $30 the day after hitting $35, then he’ll have $$$ to spend elsewhere. I believe the current minimum requirement is 25%; if someone knows better, let me know.

A fictional example of short-selling is in the movie Trading Places – though it involves short-selling commodity futures rather than shares. In it, Louis Winthorpe III and Billy Ray Valentine short-sell orange-juice futures, based on inside knowledge that they rather illicitly obtained, and bankrupt the Duke brothers, who thought that they had illicit inside knowledge that OJ futures would rise.

I don’t disagree with your premise, but there are valid reasons to short even if you your knowledge base is the same as everybody else’s (i.e. the news).

Company “A” has just released a product that makes Company “B”'s obsolete, or Company “B”'s CEO has just been accused of fraud, or any number of other events can make it a reasonable bet that Company “B”'s stock will go down in the short term. Something like a terrorist attack will depress the whole market. The real estate market is hurting now because of the home bubble bursting. These effects often last beyond a single market session, making shorting the stocks a not-unreasonable action. Whether it’s worth the considerable extra risk is an individual investor’s decision: when these “downers” turn around, it’s often abrupt.

When you are “long” a stock you own shares that you can sell for whatever the going price is.

When you are “short” a stock you owe an obligation to deliver shares at whatever the going price is even though you do not actually own any of the stock. The transaction that sets this up is called a short.

When you short a stock you are essentially selling shares you do not own. These shares are “borrowed” from an actual owner in the sense that the broker earmarks that amount of stock in someone else’s account. That owner is unaware that his stock has been earmarked; the purpose of this is to keep track of how much stock is being shorted so that the total amount of all shorts does not exceed the total amount of outstanding shares.

The ordinary purpose of a short is an expectation that the stock will drop in price. When that happens, the creator of the short is free (but not obligated) to buy the stock on the open market at the reduced price and thus fulfill the obligation to deliver the amount of shares that were shorted.

A short position can be held indefinitely. However because you owe the obligation to deliver the shares, the broker will usually require you to maintain enough money in the account to cover the short. If the price of the shares you are obligated to deliver rises from 10,000 dollars when you took the position to 20,000 dollars, the broker is going to want to make sure you can buy back what is now a 20,000 position. There is no upper limit to this except your tolerance for risk and your patience, as long as you have enough money to cover the short at the current price. Should the stock drop back to 5,000 you can buy the stock on the open market and cover the short. Should it go to 40,000 then you will have to have that much money (or credit) in your account.

The fundamental difference between long positions and short positions is that prices can go up indefinitely but only go down to zero. A long position which began at a price of 10,000 can drop to zero (Enron, say). A short position which began at a price of 10,000 can rise to millions (Microsoft, say).

In the near-term, however, it’s a perfectly reasonable bet to make. It’s simply the opposite of buying a stock and hoping it rises. You short a stock and hope it falls. The only tricky thing is that part where you don’t actually own the stock you sell. What you really do is create an obligation to deliver the stock to a buyer, with the plan in mind that you’ll buy it for delivery later, when it’s cheaper, and pocket the difference between today’s and tomorrow’s price.