Can someone explain short selling to a non-investor? How in the world can a person make money when a stock price goes down?
The example I’ve read is that an investor thinks a stock is overvalued at $25. So he SELLS STOCK THAT HE DOESN’T OWN (!) and then hopes that the price falls. If it drops to $20, he will have made a profit.
How can an investor sell stocks that he doesn’t own? How does he make money?
He borrows it. Then he sells it at $25.
Let’s say he borrows it for a week. At the end of the week, he buys the stock and returns it to where he borrowed it from.
If the stock has gone down, he can buy it for $20 and makes $5 a share profit. Problem is, the stock could go up, and then he has to buy it at a higher price and loses money.
It has to be returned at a certain time, no matter what the price is then. It’s an investing strategy that takes balls of steel.
Short (finance) - Wikipedia for more info.
I’ve already read the Wikipedia entry, and it didn’t make any sense to me.
But does he not have to invest $25 at the outset? How is any money made from this method? Is there no original outlay? Why is the lender forced to buy the stock back at a lower price?
No. That’s the trick. There’s no original outlay.
The lender doesn’t buy back the stock, it is bought and returned by the borrower.
What do you mean by returned?
It’s not really a cash transaction, it’s a stock transaction. Let’s say you hold 100 shares of MSFT. I think that the stock price of Microsoft will go down with the Vista launch, so I borrow 50 shares from you and sell them at the current market price. (It closed at slightly above $30 today, so let’s call it $1500.) So I now have $1500 in cash but I owe you 50 shares of MSFT. Those shares do not have to be worth $1500 when I give them back to you. Since I’m shorting stock, I want the value to be lower, say $25 a share. So we reach the end of the loan period and I owe you 50 shares. I’m lucky and the price is indeed now $25 a share. That means it costs me $1250 to buy 50 shares, meaning I pocket $250. If the price of MSFT is instead $35 a share, it will cost me $1750 to pay back your stock, for a net loss of $250. The lender is not the one who buys the stock back. The borrower buys the stock back and then gives that amount of stock back as payment for the debt.
Now, in the US, you have to put 50% of the value that you’re borrowing in an account with the brokerage you’re doing this short with. I’m sure the lender picks up a small profit in fees as well.
Let’s say Time Warner has gone on a hot streak for a couple months, and gone from $17 to $22. I believe that it’s not worth $22, and will drop.
I go to my broker and say, “Yo, loan me 100 shares of TWX.”
“Why, certainly,” my broker says. “Pay me back in a week.”
I then sell that stock. Now I have $2200 and 0 shares of stock.
The week passes, and I have to buy the stock; I have to return it to my broker.
I was right - the price went to $19; I buy 100 shares for $1900. I return those shares to my broker and have $300 profit in my hot little hands.
I was wrong - the price kept going, to $25; I buy 100 shares for $2500. I return those shares to my broker and have a $300 loss.
Does that help?
Is it correct to characterise the situation as one of “borrowing”? Generally one cannot sell what one does not own. One cannot sell what one has merely borrowed.
I would have thought that legally what occurs - rather than borrowing - is that you buy stock now but at a price to be set by reference to the market price at some agreed later date. It may be that this is referred to as “borrowing” but it isn’t, legally speaking.
Or alternatively share trading exists in its own little pocket of the law, which would be unsurprising…
Keep in mind what what Frank said about balls of steel. Why? Because regular trading has limits. Example: you invest $10,000 in some stock, which goes belly up. You just lost $10,000. That’s all you can lose. That’s not true with short-selling. There is no upper limit to how much you can lose. Example: you short-sell $10,000 worth of some stock you think is gonna tank. It balloons up to $100,000 worth of stock and stays there. You now owe $90,000.
So I guess the stock market scene in Trading Places when Eddie Murphy and Dan Ackroyd was trying to destroy the bad guys was short selling? I never did understand that scene, being a non-investor myself.
Yes, they were short-selling. However, they were short-selling commodities futures, i.e., the promise at some future point in time to sell a generic commodity. In the particular case, it was frozen orange juice futures, and the value of OJ futures at the end of the trading day depended on a government report on the orange harvest.
Rather than think of ‘borrowing’ the actual shares (why would anyone lend them to you for nothing?), think of markets.
Markets can be for loads of things.
Now you can bet with your mate on a sports result without a market. But betting shops provide a market where you can bet against the bookmaker.
Take it one step further, and you can visit a website that matches your bet against someone else also connecting to the website who wants to bet the other way. Here the market doesn’t set odds - it’s an introduction service for gamblers (and takes a small fee for each intro).
Now let’s dive into the commodity futures market :eek: , like the one featured in ‘Trading Places’.
Suppose you are a giant chocolate 
company. You need a regular supply of cocoa beans. Preferably you would like the price to be steady (or at least predictable). Otherwise if the harvest is bad, then the price will rise because of shortage and you will face a loss because it’s more expensive to make chocolate.
So you use the cocoa bean future market. You state that you will buy x amount of beans every month (to make the amount of chocolate you expect to sell).
Meanwhile investors (or financial gamblers, if you like!) are studying the cocoa bean producing countries. What is the weather forecast, chance of a coup - anything that would affect the harvest.
They then offer to sell you cocoa beans at a set price for any future month you want.
Now you might pay a little over the odds, giving them a profit (and a reason to do all this). But your reward is that you know what price your raw ingredients will be for months to come. And that matters to large companies.
Hopefully you’re still with me. 
So there is a constant futures market in all sorts of commodities. But any market attracts speculators. They may think that a new weather forecast changes things. So they will buy up contracts to supply cocoa beans at e.g. price $1000 / ton in July, because they think there will be a bumper harvest in July, leading to a big fall in the price (say to $500 / ton), leading to a nice profit for them when they actually buy the beans.
Note they don’t have to own any cocoa bean plantations or factories. They are matching their judgement against the company prepared to pay for price stability.
Nitpick: You have $2200, and an IOU for 100 shares of TWX. In a way, it could be thought of as owning -100 shares.
You knew that, but it’s an important point to stress: money isn’t being created out of thin air here. Benighted, don’t think of shares as physical objects, it’s easier if you think of them as a unit of currency that can be borrowed, exchanged, owed or traded just like dollars. Just as it’s possible to have a negative dollar balance (give me 100 shares and I’ll promise to give you $2200 later) it’s possible to have a negative share balance (give me $2200 and I’ll promise to give you 100 shares later). Where and who the shares actually come from rarely ever becomes an issue.
A few things that haven’t been mentioned;
Because of the financial risks involved in short selling, you have to be approved by your broker for this kind of activity (you need to have the assets to cover potential losses).
Right now there is a rule that says that you must sell short on an uptick of the stock price. You can place the order, but it won’t be executed until the price goes up. There is currently talk about eliminating this requirement.
Also (although I’m not 100% on this) the broker can close out your position without warning when the shares you were lent are no longer available (i.e. the owner sold them and there are none available to take their place).
You can’t just ask the broker to lend you the stock without any cash outlay.
In the US, you have to put up 50% of the current stock value before the stock can be lent to you in order to short. If the stock goes up, it’s considered a margin account and you are subject to limits on that; the more the stock rises, the more money you need to put in to cover the margin.
Plus there are transactions and interest fees.
However, there isn’t a time limit on a short sale*. You could theoretically hold the stock indefinitely and hope it will drop to a point where you break even. But the margin fees and interest on margin and broker’s fees would probably make it impossible. It’s money down a rathole and few people smart enough to handle short selling are dumb enough not to cut their losses.
As for getting the shares, most brokers have their clients keep stock in the “street name” (i.e., the brokerage is the official owner, though you get the proxies, etc.). If you want to short 100 shares of TWX, the broker sells some of the shares that other clients own under the street name. If that client want to sell his own shares that the brokerage sold for you, the brokerage will just sell TWX from another client’s account. It’s essentially a shell game, but is highly regulated, so fraud is nonexistant.
*Options, on the other hand, do have an expiration date.
Thinking of it as borrowing is simpler for me.
But you’re not actually spending that money; it’s still in your account.
Perhaps we’re in angels dancing on the head of a pin territory here.
Conceptually, short selling is the exact opposite of buying on speculation*. When you speculate, you borrow money to buy stock in the hopes that the stock will be worth more than the money you borrowed. When you short sell, you borrow stock to buy money in the hopes that the money will be worth more than the stock you borrowed.
Take another look at Frank’s example of short selling:
Now, let’s take a look at the equivalent example for speculation:
See the similarity?
The only real difficulty here is getting your head around the notion of using stock as currency to buy cash. But once you’ve got that, the rest is easy.
*Note that there may be different legal issues associated with speculating and short selling. If you’re making any investment decisions, get your advice from someone other than an anonymous stranger on the internet.
I’m going to be a billionaire, just as soon as I find a broker who’ll let me short those penny stocks I keep getting spam about 