Welcome back to the Winning Investor! I am your host, Andrew Horowitz, and I'm here to give you the simple, quick and dirty tips to becoming a winning investor.
In the last episode, I discussed leveraged and inverse exchange-traded
funds. Inverse funds -- in essence -- are short-selling a market or a sector, and can be a useful hedge against market declines, however they're certainly not for everyone.
In this episode about the basics of short selling a stock, we will discuss a topic that can be risky for newer investors, but anyone can benefit from basic knowledge of what it means to "short" a stock.
How Can You Short Sell a Stock?
When someone is going to "short" a stock, it means that they have borrowed shares from their broker and have sold the shares in hopes of buying them back later and making a profit in the event the share price of a company falls. So short selling is essentially selling a stock that you don’t actually own. Let’s back up so I can explain exactly how short selling works. You can short sell a stock when you work with a stockbroker and get the broker to lend you a stock from his inventory, from another one of the broker’s clients, or from another brokerage firm. Because the broker is only lending you the shares, you must eventually buy the exact same number of shares to replace the ones you’ve borrowed. In order to let you borrow and short sell stocks, brokers charge a small fee.
What is Short Selling?
The simplest way to think of "being short" is to think of buying and selling a stock in reverse. When we do our research and find a stock that is undervalued, we want to buy that stock and then hold it for a period of time and then sell it later in hopes that we make a profit. It's like the age-old saying "Buy low, sell high."
If you flip the terms around, you get what it's like to short stock, though it certainly does take some thinking to wrap your head around. Instead of buying stock as their first action, short sellers will actually sell the stock in a company they feel has weak fundamentals or think will come into some sort of trouble that will lower its stock price., Then if the price does decline, the short seller will buy back the shares they just sold short for less money than they sold them for. If the price does go down, then they made a profit.
In essence, the short-seller wishes to "sell high first, and then buy low later."
A Real World Example
Let's use a real-world example of something other than stocks. Let's say your friend just bought a nice new video camera for $500 from your favorite electronics store. You think you know something your friend doesn't about the camera, and think it will go on sale next week or next month. You ask your friend if you can borrow the camera and your friend agrees.
You then rush to eBay and then sell the camera to the highest bidder who happens to pay you $500. You pocket the $500, but you have an obligation to return a camera to your friend by the end of the month, so at some point, you are going to have to buy the exact same camera, hopefully at a cheaper price than $500.
Let's assume that you were correct, and the same electronics store has a 20% off sale next weekend. You rush to the store and buy the same camera which is on sale for $400 now. You quickly return the camera to your friend, and you keep the difference between what you sold the camera for on eBay -- which was $500 -- and what you just bought at the store for-- $400. This means you pocket $100!
The Basics of Short Selling in the Stock Market
That is the basic logic behind short selling in the stock market. Your broker or some agent has to own shares of a company -- let's say Google -- and then he loans the shares to you so you can sell them. You -- in theory -- pocket the money from the sale but have an obligation to buy back the shares to return them to your broker at a later date, and you promise to pay a small fee for this privilege. If the price of Google falls, then you can buy back the same number of shares and return them to your broker and pocket the difference for what you "short-sold" them for and then "covered long" or bought back the shares. This now happens instantly at the click of a button!
However, shorting isn't for everyone. Think of what would happen if the price of the camera-- or of Google-- rose! If the price of the camera rose to $600 at the electronics store, you would have to take the $500 you got from selling the camera on eBay and then go to the electronics store and buy the new camera for $600. Where would the extra $100 come from? It would come out of your hard-earned cash to meet your obligation to return the camera to your friend.
The same thing happens in the stock market when someone short-sells a stock and the price of the stock rises: they have to pay the difference out of their own pocket -- in the form of losses -- to meet their obligation to their broker.
The same logic happens when you purchase an inverse fund: you hope the price of the index goes down, which would make the price of your fund go up.
Short-selling is generally not advised for very long-term investors, and is mainly used by traders or those wishing to hedge part of their portfolio using other stocks they feel are fundamentally weak and likely to decline in value.
We'll discuss more about shorting stock soon, but it's important for investors to have a basic understanding of what shorting means and when it can be beneficial.
Don't you wish you had shorted some stock through most of 2008? That's where shorting can be helpful to a winning investor's portfolio... but only if he or she is aware of the risks of selling stock short.
Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show.
And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market wishing you all the best on your quest to investment success.
