How Short Selling Works

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


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


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


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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my name is Richard coffin thanks for

joining me today