How to sell short
How Short Selling Works
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the big short is probably one of the
most popular films on the topic of
investing it's a star-studded movie that
follows the real story of three groups
of people who short or bet against the
housing market for billions of dollars
right before the 2008 real estate crisis
as you might expect our heroes end up
making quite a bit of money but how
exactly does a short work well in the
movie the positions are taken through
what are known as swaps a derivative
agreement that is taken with the banks
but for common investors short positions
typically involve individual stocks make
them easy enough to take but be warned
shorting comes with a lot of risks on
top of charging you expenses you don't
normally see with standard investing
shorting also offers a skewed payoff
where you face a limited upside in an
uncapped downside meaning you could lose
an infinite amount of money
theoretically anyway so before you
decide to short something let's go over
the strategy in the risks involved on
today's plain bagel
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shorting also known as short selling is
a trading strategy where an investor
sells a security today and buys it back
in the future hoping that the price of
the security will go down it's
effectively the opposite approach to a
traditional long position where
investors buy today and sell at some
point in the future to cash in hopefully
after the price has gone up
it follows the same buy low sell high
mentality as long investing but it just
reverses the order of the motto so
investors sell high today and hope that
the price will go down so they can buy
low in the future now
shortening on a stock is a bit more
complicated than going long on a
position so let's go through a running
example to explain how the strategy
works in the risks it poses imagine you
have to investors who decide to take
opposite positions in plain bagel Co the
company stock currently has a market
price of $10 investor a decides to buy
1,000 of these stocks thereby investing
$10,000 one investor B decides to short
1,000 stocks
thereby selling 10,000 dollars worth of
the investment now I know what you're
thinking how the hell do you sell a
stock that you don't own well oftentimes
the process involves selling a borrowed
security for example in a brokerage
account you can often sell a position by
borrowing a stock from your broker and
then shorting that way leaving you with
the proceeds from the sale the money you
make from the sale obviously doesn't
really belong to you since you sold
someone else's stock to get it but
eventually when you buy the security
back known as covering your short you'll
be able to return the stock and keep
whatever money is left over which is how
you profit from the trade so going back
to our example the stock price falls
from $10 to $5 investor a will lose
$5,000 one investor B will gain $5,000
since they'll be able to buy the stock
back for a lower price and keep the
remaining sales proceeds on the other
side of things if the stock price
increases from ten to fifteen dollars
investor aid will be up five thousand
dollars while investor B will be down
five thousand but this raises an
interesting question
up until this point investor B hasn't
actually contributed any of their own
money so how is he going to buy back the
stock for more money than what's in the
account well this is where the concept
of margins come into play
you see too short a position an investor
needs to post what's known as an initial
margin a 50% into their account to act
as a buffer should the investment lose
value
this means that investor B would have
contributed five thousand dollars of his
own funds at the beginning of our
example to accommodate for any losses
the amount still belongs to the investor
but it's held as collateral by the
broker to ensure that investor B can
afford to buy back the share in the
future investor B will also be
responsible for what are known as margin
calls a process that occurs when the
margin becomes insufficient for example
in the event that the share price rises
to $15 investor B would receive a margin
call to replenish their cash buffer
based on what's known as the maintenance
margin since there's no more wiggle room
in the account to accommodate for
further losses so a big difference
between shorting and going long a
position is that you can only short in a
margin account while this has its
downsides
it does add leverage to the investors
return what do I mean by that well let's
go back to our example let's say that
our share price falls from 10 to 5
dollars this would leave investor aid to
lose $5,000 an investor be to gain
$5,000 on an absolute basis these
returns equate one another but on a
percentage basis taking into account
margins they're actually quite different
you see investor a has lost roughly 50%
of their investment but since investor B
has only contributed five thousand
dollars of his own money to this margin
account he's actually gained 100 percent
of his investment doubled the percentage
of investor a because borrowing is
involved with shorting investor B will
see his returns amplified though this
goes both ways
percentage losses in the short position
will be double what they might have been
for investor a so will decline a 50% for
investor a would translate into a one
hundred percent decline for investor B
so short positions not only flip the
percentage return received by investors
but they also amplify them both on the
way up and the way down but here's where
we get into the distinct disadvantages
of a short position namely short
positions come with unique costs that a
standard long investor won't face for
example if the stock you borrow pays a
dividend you'll actually need to pay
this amount to your
broker meaning that you'll face a cost
equal to whatever dividend the stock
pays short positions also charge
investors in interest rate on the value
of the stock you borrowed after all
since you are borrowing and selling
someone else's security you need to
compensate them in the same way that you
would compensate a bank with interest on
a loan
typically the rate charge on a short
position can range anywhere from 2.5 to
20 percent but it can be higher for what
are known as hard to borrow stocks
highly volatile or small cap positions
so needless to say shorting the stock
can be quite a bit more expensive than a
simple buy but for the most part these
expenses are fair the interest makes
sense since you are taking a leveraged
position and since you are trying to
inverse the return of a long position
it's only natural that you pay out the
dividend received from the stock
but there are some absolute
disadvantages involved with the short
strategy some of which may very well
turn you off the idea of ever trying to
short a stock for one short strategies
face what's known as buy-in risk the
chance that a broker will make you
prematurely cover your position this can
occur for a number of reasons a broker
may need to return a stock to the
portfolio they took it from or the stock
may simply see a surge in demand but the
end result is that you may be forced to
close your position at any time this is
a pretty significant drawback especially
when it comes to waiting out market
volatility in our example perhaps
investor B is confident that certain
factors whether it be regulation or
technological change will cause the
stock to crash in two years time but if
the price surges in the near term they
may be forced to realize a loss even if
they end up being right on top of this
when shorting a position you may
experience what's known as a short
squeeze when a heavily shorted stock
sees its price surge because the
investors shorting the stock need to
cover their physician since investors
who short sell have a appropriately
shorter time horizon than long investors
this is a chance that they buy back the
stock around the same time which can
lead to a surge in the price and make it
harder for you to cover your own
position without realizing a loss so as
you can see there are some distinct
disadvantages with shorting a position
which alone may lead you to stay away
but perhaps the biggest risk with short
positions has to do with their skewed
payoff with her to investors longing in
shorting the $10.00 stock we face to
risk reward profiles on the one hand
investor a can theoretically earn an
infinitely high return the $10,000
investment in the ten dollar stock could
double triple quadruple in value as the
stock price climbs to 20 30 $40 or
higher on the downside the most she can
lose is the money she's invested the
$10,000 which would only happen if the
stock fell to 0 a pretty drastic outcome
now investor B actually flips the risk
reward here if the stock drops down to 0
ignoring fees they can achieve a 200%
return since they are able to keep the
$10,000 your profits from their $5,000
investment on the other hand if the
stock instead climbs to 20 30 $40 or
higher they can lose 200 400 600 percent
or more this means that you can lose a
lot more money than what you've
initially invested and indeed this very
feature has had devastating impacts on
the investors this is why many investors
tend to stick with long lonely positions
for many of the return is simply not
worth the risk and on top of the fact
that you're going against the natural
upward bias of stocks you're more or
less betting against a company that is
actively trying to prove you wrong short
selling certainly does play an important
role in the world of investments and
indeed you can make a lot of money by
placing the short bet against a
deteriorating stock but if you're
looking to speculate with short selling
tread lightly you may end up buying off
a lot more than you can chew thanks for
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comment down below for the plain bagel
my name is Richard coffin thanks for
joining me today
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you
