Photo: Ian Muttoo
Imagine you knew someone wouldn’t be using their car for six months, and that they were willing to loan it to you for a small fee, so long as you returned them the same make and model six months later. You take the car, sell it, and buy another back in time to return it to the willing lender.
Since you expect that the value of the car will drop, you imagine you can buy it back for cheaper than the amount you sold it for. You pay the lender his or her fee, and keep the difference between the sale and the buyback.
The Basics of Short Selling
It may sound a little screwy, but that’s precisely how the mechanism of short-selling works. A short-seller borrows a certain amount of shares from a stockholder in a company. The short seller then sells those shares for their current market value. At a later time, they buy the same number of shares back. (This step in the process is called “covering” the short sale.)
If the stock has dropped in price, the short-seller makes a profit; if the price has risen, the short-seller nonetheless has to return them to the lender, and thus takes a loss. Technically, a lender of shares can force the borrower to cover at any time. But, in practice, this rarely happens. Typically, there is a large number of shares available for short-selling, usually the property of mutual funds and pensions.
Short-selling is a much shorter term tactic than other investment strategies. Essentially, you’re betting that the price of a stock will drop in the near future. To be a sound decision, you’ve got to be relatively sure that the stock in the company is overvalued at current market price. Or, perhaps you foresee a force in the market that will make the company less competitive and desirable in the short-term. It’s a very risky proposition in a stock market.
Let’s take another example, this time using an imaginary stock as an example.
Currently, Sweet-tooth Confections just released a new dark chocolate truffle that is simply flying off the shelves, and shares are selling at a price of $10. You believe that this number is simply too high because the market can’t sustain it for very long.
You believe that other manufacturers are poised to release similar products that will cut into Sweet-tooth’s market, leveling the playing field and bringing the price down from its temporary high.
You expect that in the short term, the price will drop to around $7. You short sell 100 shares for a total of $1000. The price drops to 8, and you decide it’s a good time to cover. You purchase 100 shares for $800, and keep the $200 difference, less whatever fee you agreed to pay the lender.
As a last thought, being that a misplaced short sale will force you to take a loss, many brokers require credit checks or cash on hand before approving you for short sales. Before beginning a short sale strategy, it would behoove you do to do plenty of research on the mechanisms, and how it could be part of a sound investment strategy.
Many methods exist, purporting to spot opportunities for profit in short-selling. Give it plenty of thought before you give it a shot. The practice is inherently risky, but many investors swear by it and if you know your stock market, money can be made.
Published or updated April 5, 2013.