I was talking recently with one of my tax clients about investing and the topic of short selling came up.
“In finance, short selling or “shorting” is the practice of selling securities the seller does not then own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond, in contrast to the ordinary investment practice, where an investor “goes long,” purchasing a security in the hope the price will rise.”
What does that mean exactly? I’ll try to explain it with an analogy.
Pretend that you are at a 4 day concert and that the stock you would like to invest in is water.
In order to make profit, you need to decide whether or not you believed that future circumstances would lead to the increase in water prices or the decrease in water prices. The most simple way to do this is by checking the weather forecast.
Hotter weather = Increased water prices
Colder weather = Decreased water prices
You start the first day with : $1,000
The first day of the concert is a mild day and not many people are buying water. You ‘know’ that tomorrow is going to be one of the hottest days in the summer. Imagine how much money you could make if you bought 1,000 bottles of water today $1/bottle today with the expectation of selling those same bottles of water at $5/bottle tomorrow when everyone is dying of thirst. When you purchase the water at $1/bottle, you are ‘going long’ with your investment.
You start the second day with : 1,000 bottles of water
The second day, when the sun is at its peak, you sell all of your water bottles at $5/bottle and are left with $5,000 in cash. Other individuals see how much money is being made but they have a brilliant idea: wait another day so that they can sell their water tomorrow at even higher prices when it gets hotter.
You have calculated that tomorrow is going to be a very overcast day and that the decreased demand for water is going to cause the price to drop back to $1/bottle. You decide to make a deal with some of the people that are holding onto their water until tomorrow. You agree that you can borrow 1,000 water bottles for a day as long as you give back the 1,000 bottles tomorrow. (since the people you are borrowing the water from want to sell their water tomorrow at $7.50/bottle) You immediately take the 1,000 bottles you borrowed and sell them for $5/bottle. You have just short sold 1,000 bottles of water with the hopes of buying the water tomorrow at a lower price to return to the individuals you borrowed from.
You start the third day with $10,000 in cash (from sale of your water from the 1st day’s purchase and the water you borrowed to sell) and you still owe 1,000 bottles of water to the people you borrowed from
As the third day comes around, it turns out that you were right. It is a cool summer day and people aren’t willing to pay $5/bottle (much less the $7.50 the other water sellers were hoping for); they are only willing to pay $1.50 per bottle. You immediately buy 1,000 bottles of water for a total of $1,500 and return them to the people you borrowed from. You still have $8,500 and believe that the weather on the fourth day is going to be a little hotter so you decide to take that $8,500 and purchase 5,000 bottles of water a $1.50 for a total of $7,500. You have switched your position from being ’short’ to now being ‘long’ with your investment
You start the fourth day with $1,000 in cash (your initial position)and 5,000 bottles of water. Any water you manage to sell will leave you with profit!
As the fourth day begins, it doesn’t get much hotter but you are still able to sell your 5,000 bottles of water at $2/bottle for a total of $10,000.
You end up with $11,000. You started with $1,000. In the past 4 days, you have made $10,000 by initially going long with your investment, then going short, going back to long, and then completely cashing out.
If you had come to the concert on the first day, purchased the water at $1/bottle (gone long)and waited until the fourth day to sell the water at $2/bottle, you still would have made a profit of $1,000 but by using the advantages provided by going long and by going short, you have increased your overall profit by taking advantage of the changes in market prices.
Enough with the analogy.
Hot weather is the same thing as an economic boom. There are plenty of buyers, company profits are growing at a decent rate, and stock prices are going up. During an economic boom, you buy.
Cold weather is the same a recession. Prices are falling, people are skeptical about the future, and sellers outnumber buyers causing rapid market declines. This is an excellent time to use your cash to buy undervalued stocks and to short sell. Since it is possible to lose money when short selling (if the stock price goes up), it is advisable to keep track of what is happening in the market and to maintain the same profit/loss sale rules that you do when being a ‘long’ investor.
I hope that this explanation has provided you with a greater understanding of what short selling is.
Short Selling: Introduction
Stock Strategies : Short Selling
NAKED SHORT SELLING