Short Selling: A Primer

We all know that the classic idea of investing is to buy low and sell high, proffering off the difference.  Traditionalists, people like my grandfather, believed wholly in this, and it’s the premise behind the moniker, “Make your money work for you.”  The biggest names in the investment world do this over various time frames ranging into the decades, dealing in the ebb and flow of the global economy and, more importantly though less spoken of, the emotions of the other people investing in it.  At best and over the long haul, such an investor may make more than 10% per year, though the average market return is somewhere around 7% per year.  It beats a savings account and CDs, to be sure, but it’s not the road for me; I want to short sell.

 

Short selling is the somewhat pessimistic, inverted cousin of the above paragraph, often referred to as going long.  Short selling is first selling high, then buying low, and this is where the confusion starts.  How can anyone sell something they don’t have?  Borrow it.

 

Let’s take a step outside of securities for a moment to illustrate.  A car dealer (stock broker) has many different cars on their lot (stocks in their portfolio) that they own.  They agree to let you rent (borrow) one car in exchange for a daily fee (interest).  You (a stock trader), borrow a car, and immediately sell it at the current market value, say $10,000.  The daily rent is pretty low, maybe only a few dollars, but the rate at which the value of the car falls is considerably higher.  A year goes by, and you buy an identical car from someone on the used car market, this time not for $10,000, but $5,000.  The total rent charges were only a few hundred dollars, say $500, and since you bought the car at half the price you sold it, you profit $4,500 dollars on the whole thing.  Line by line, it looks like this:

 

Sell Car:               +$10,000

Buy Car:               -$5,000

Pay Rent:             -$500

Total:    $4,500

 

The idea translates well to stocks, except that stock prices can and do rise with time.  So, you borrow shares from your broker, immediately sell them at the market value, wait for the stock to drop in value, buy the shares back, pay the interest, and go about your day.  The broker wins because they get interest, and you win because you sold high and bought low.  But as with traditional investing, that’s the catch: when does one sell, and when does one buy?  Those are questions for another time.

Leave a Reply

Your email address will not be published. Required fields are marked *