Nearly everyone knows the mantra of buy low and sell high. This is a great way to make money when asset prices are rising. Many mistakenly believe that this is the only way to make money. On the contrary, you will find there are countless ways to make money in the world, and there is even a way to make money when asset prices, such as stocks, take a big tumble. Making a profit when stocks go down is called shorting a stock.
To short a stock is a simple yet genius idea. The first question is how does someone make money when the price goes down? When an investor shorts a stock, they first borrow the stock from a long-term holder such as a mutual fund or large institution, and they make an agreement to return the borrowed shares at a later date. They immediately sell the stock at the market value. Then they wait for the share price to go down before repurchasing the shares to return them.
Let’s take a look at a real example. Let’s say you wanted to short Bank of America at $30. You borrow 1,000 shares and sell them at $30 each. You pocket $30,000 from the transaction. The price of BAC stock goes down to $20, and you decide to cover your short position. You repurchase 1,000 shares at $20 which costs $20,000. Because you initially sold the 1,000 shares for $30,000 but repurchased them for $20,000, you have made a profit of $10,000 or 33.3% while the underlying shares have plummeted 33.3%.
Shorting stocks is considered an aggressive play, and it has many risks. The most obvious risk is the possibility of an unlimited loss. When you purchase a stock, you can only lose your initial capital. For example, if you bought 1000 shares of BAC at $30 and it went to $0 per share then you would have only lost your initial $30,000 investment; however, with shorting you can lose far more than your initial investment. If you shorted 1000 shares of BAC at $30 and it shot up to $100, then you have lost $70,000. This is far greater than your initial $30,000 investment. Because the lowest a stock can go is $0, the losses are limited when you are long a stock. There is no upper limit on a stock price though, so shorting has the possibility of unlimited losses.
Another hassle with shorting stocks is the cost of shorting. There is generally a Cost To Borrow Fee that is charged to the investor each day that he is borrowing the shares. Depending on how easily one can find shares to short, this cost may be negligible or noticeable. If you are shorting a dividend paying stock, then you will have to pay the dividend of the stock to whomever you are borrowing the shares from. The market dynamics of shorting can also leave you in a heap of trouble if good news comes out and the stock goes up. This is known as a short squeeze when a heavily shorted stock skyrockets up due to many investors short covering. When you cover a short position, you have to repurchase the shares, and all of this results in many investors buying a lot of stock which pushes the share price very high. If you are short, this can mean a hefty loss for you. Because of these risks, many short positions are kept to 2-3% of a portfolio’s value at most.
Shorting is a very useful strategy if you are very convinced that the market or a particular stock is about to have a downturn. It is a surefire way to take advantage of economic rough patches, but it has a multitude of risks. One way to eliminate some of the risks of shorting is to create a synthetic short position using options. I will write an article on this topic at a later date.