I understand the principle of shorting a stock. You borrow the stock when it’s high and pay it back when it’s low. The difference is your profit. Is there a time limit in which you must repay? I sometimes hear the term short squeeze. What does it mean with regards to short stockholders? (and please try to refrain from the Mickey Rooney/Tatoo/Tom Thumb/etc. jokes. They’ve already crossed my mind. 
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Almost, you borrow the stock and sell it when it is high. Buy it back and repay your debt to the borrower when it is low.
Shorts of course are wanting the price of a stock to go down. If it starts to go up, they may decide to cut their losses and sell. Only they are not selling. A short BUYS to cover his position. Therefore a short squeeze occurs when the price of a stock trends upwards and a flurry of ‘short covering’ takes place, sometimes pushing up the price even more.
I hope that makes sense.
I am not a stockbroker.
My understanding is that there is a futures market, which is very volatile (i.e. big potential gains and losses).
A large chocolate company wants a steady supply of coffee beans. They offer to pay (made up figure) $1000 for a ton of beans in April, May, June etc. (In real life the price would undoubtedly vary each month.)
Speculators, who hopefully know something about the coffee bean harvest offer to supply the company with beans each month. (They don’t have to own any beans, just promise to get some.)
When April comes around, the weather is fine and coffee beans are available at $750 per ton. The speculator makes a $1000 - 750 = 250 profit per ton.
However in May a hurricane destroys most of the crop. Now the price jumps to $2000 per ton. The speculator loses $1000 - 2000 + 1000 per ton.
Note that the company gets its raw materials at a known price. The risk is taken by speculators, who have to pay for delivery in the month they chose.
I think that buying short is gambling the future price one way (as opposed to going long).
You can short-sell futures contracts, but short-selling stocks has nothing to do with the futures market.
MrFloppy is on the right track. A short seller, as you noted, is betting that a stock will decrease in price. He borrows stock from his broker and sells it at the current market price. Let’s say that he borrows $10,000 worth of a particular stock, 1000 shares at $10 per share. If the stock price drops to a lower price, the short seller will buy stock at the lower price, pay back his loan, and pocket a profit. If the stock rises in price, the short seller can hold the stock indefinitely, hoping that it will eventually drop. He may decide to cut his losses before the stock rises too much, buy the stock at $11 or $12, and pay back his broker, taking a loss. A short squeeze occurs when short sellers who want to buy stock and bail out actually push the price up by virtue of their own demand. This usually happens with small cap stocks which have relatively few shares available at any given time. There is no limit to how long a short seller can maintain his short position, as long as he has the money to pay interest to his broker.
Hmm Glee, you are describing selling Forward contracts - not quite the same thing, but like most transactions could be synthesized into something like a short, although Shorting involves immediate settlement.
In the UK Shorting a stock used to work like this, you own nothing, you tell your stockbroker to sell 1000 shares in DOOMED PLC and the money turns up in your account.
On settlement day (once a month) you either pony up to buy the shares back, or pay a Contango fee to carry over the potential debt.
Since settlement is now virtually instantaneous I would imagine that a reputable stockbroker would direct you to the Futures or Traded Options market, and for the average punter, suggest ‘buying’ a ‘put’ option as the risk is limited to the money paid up front and no shares really change hands.
A slightly riskier version is Spread Betting which is Ok if you have a good price feed and are sober while the markets are open.
@Glee, I imagine that you are thinking of a large UK chocolate manufacturing company that had a buyer who went totally mad in the 1970s and lost a bomb chasing the losses.
My understanding was that they kept quiet about that fiasco
Short positions (on common stocks, commodities, or anything else where a market allows short positions) have a major inherent drawback relative to long positions (the normal case):
Your maximum gain is 100% – whatever you sold short crashes, and you short cover (buy back) at a price of zero. But your maximum loss is unlimited – the item’s price could rise forever, until legal requirements force you to cover the position (a short squeeze) or until you are forced into bankrupcy to cover the short position.
I am not a financial advisor or any other sort of financial professional; I’m simply presenting a fact of short positions. Given that, I strongly suggest that trading in short positions is NOT something to be learned from a public message board.
Since shorting a stock involves having a margin account, you may be required to pay more into your margin account if the stock rises too much. In addition, you pay interest fees to the broker. So if the stock doesn’t drop fast enough, you’re losing money on interest, and if it continues to rise you’ll have to pay into the margin account. You get some of that back when you finish the transaction, but you do need to tie up the funds until you sell, and if the stock continues to rise, you’re just throwing good money after bad.
Certain options let you benefit from a stock drop with less risk.
Not quite correct. Margin is borrowing money; a short position is borrowing a tradable property. What you’ve described is a margin call – the value of the long positions in the account is not enough to allow the amount of the money loaned to you on margin, and the broker makes you put money into the account or else they sell your stock for you.
I don’t know the details, but uncovered shorts (i.e. when you don’t actually own the stock you’re shorting) are treated by brokerages like margin borrowing, and if the value of the shorted stock borrowed goes up too high, you can get a margin call. If you don’t make the margin call, the brokerage can sell out your position.
Sometimes investors will want to make “covered” short sales, where the investor owns (is long) at least as many shares as he or she sells short. There are several reasons to do this, with perhaps the most significant being a way to preserve the gains in a stock without actually selling and incurring capital gains tax.
All he said was that you need to have a margin account.
You do. You’re borrowing on margin, and you are subject to margin calls.
Also, the value you borrow must be paid back with interest, so to make money, not only do you need the stock price to fall, but you need it to fall enough to cover the interest.
The whole “potential loss is unlimited, potential gain is capped” thing – while true – is an essentially meaningless consideration when determining whether you want to short a stock or not.
There are other reasons for the every day investor to be wary of short selling, not the least of which is that since 1900, the Dow has looked like THIS!
Yes, please, where can I sign up to short that?
It’s graphs like that that make short sellers very wealthy.
Individual stocks are not the same as the stock market as whole. Nor are the several thousand stocks traded on the NYSE and Nasdaq the same as the mere 30 stocks that are in the Dow Jones Industrial Average.
Every single day, some stocks go up and some stocks go down. That was true even two weeks ago, when the Dow dropped 416 points. A few stocks in the overall market still manged to rise against the tide.
Short sellers are making bets on the future performance of individual stocks, not the stock market. All stocks sometimes go up and sometimes go down. While this should be blindingly obvious, people always forget this. If you can time the drops correctly, you can make money in exactly the same way as you would by timing the rises correctly. Shorting is all about, well, short-term performance. No sane trader holds shorts indefinitely. You get in and get out quickly, and hope that the differences are more than the costs of trading. Guess wrong, time wrong, and you can be hurt very badly, especially since most short traders use borrowed money. That’s why the unlimited potential rise of a stock is a very serious consideration indeed.
But shorting is a wholly other animal than the trend of the Dow. In fact, it exists almost entirely because the trend of the Dow is upward.
Fight my ignorance here, guys. Isn’t shorting also used for when you get given stock options? To protect yourself against the taxman? You short the options when you get given them and cash in either way when the options vest? The idea being that if you get given options for 1000 shares at $100 and they’re worth $200, the taxman counts that as $100,000 of income which is taxable. But if the shares drop to $100, he still wants tax on the nominal $100,000 you were given. So you short the shares, essentially selling them immediately. Or am I getting in a complete muddle?
The more times you play the “short game”, the closer you get to following the DJIA. . .you’re playing more and more times with more and more companies, and the long term performance of the stocks you try to short is going to match that graph I picked.
Oh, well, if you believe in an individual’s ability to time drops and/or rises, then we’re not coming at the problem from reconcilable points of view.
Well, you can also short index-fund ETFs, if you want to get anal about it. Shorting an S&P500 ETF is making a bet on a rather large portion of the market as a whole, rather than an individual stock.
I didn’t say they were necessarily successful. But if individuals didn’t believe they could time the market, short buying wouldn’t exist. For that matter, regular stock buying wouldn’t exist. There would be a few people who put their money in stocks and hope for long-term rises and good dividends, or else just buy index stocks. That reality describes only the tiniest percent of the market, however. Even fund managers declare they they can time the market by their very purchases and sales of stocks.
Every single stock purchase and sale is an effort to time the market. Different investors just use different timescales. Short sellers use very short timescales. Day traders - remember them? - use even shorter timescales.
Whether the cumulative effects of short timescale trading trend to match the long-term trends of the market would make for an interesting analytical exercise. However, in general the purpose of short trading is to be a market contrarian.
And no serious investor pays any attention to the Dow. The Dow is a gaudy trinket to wave in front of the suckers to draw them in.
It’s been done to death.
That’s the whole behind behind such works as Graham’s “The Intelligent Investor” and Malkiel’s “A Random Walk Down Wall Street”.
Random Walk theory? I thought we’re trying to help the OP?
Thank you all for the input. I think I have a better handle on it now.
Different market. I don’t know if the futures market is any more or less volatile than the equities (AKA stock) market but the risk is that if you can’t sell your futures contract, you’re now stuck with actual oranges, gold, oil or whatever commodity you just bought.