What Does Shorting a Stock Mean?

Personally, I try not to make broad market calls because it seems like every time I do I am wrong. Notwithstanding, you are unable to visit any financial website without seeing some type of headline about a market top or a bursting of an equity bubble.  When the media starts to “turn” on the market there is always talk of shorting stocks.

What Does it Mean to Short a Stock? or to Short the Market?

When you short the market you are essentially betting against the price of the stock.  The person attempting to bet against a particular stock borrows shares from their broker which are then sold.  The cash proceeds are placed in the person’s account.  At some point those borrowed shares will have to be paid back to the broker plus interest.

For example,

  • You believe ABC, Inc is going down in price.  It is currently worth $1/share
  • You ask your broker to short 100 shares of ABC
  • ABC will give you 100 shares of ABC that you then sell in your account.  So your account now has $100 minus any transaction costs
  • At some point in the future you’ll have to pay back those 100 shares (plus any dividends that were paid out)

So what our 3 possible extreme outcomes?

  1. The stock plummets and is now worth $.25/share.  This will allow you to buy back the 100 shares for $25.00.  Profiting $75 minus any commissions and interest.
  2. The stock goes up to $2/share.  Now you have to pony up $200 to close out the posision
  3. The stock stays the same.  You’ll have to pay the commissions and the interest on the transaction.

There are obviously gradations.

My Experience with Shorting a Stock

Zero.  I have taken positions against the broad market using an inverse ETF (SPXU for example) and earlier this year I took a position against using a put option contract (I even provided the actual outcome of that put contract).  A put contract allowed me to “put” my shares to another person at a time certain for a price certain.  For that “pleasure” I paid a premium.  The profit occurs when the stock goes lower than the premium I paid.

I think it is mainly because of the risk, but I do not know anyone whose job is not in the financial world that actually does short stocks in the traditional sense defined above.  Notwithstanding I’d love to hear some war stories!

2 Responses to What Does Shorting a Stock Mean?

  1. Good simple description of shorting stocks, but I’ve never shorted a stock, and don’t plan to now. I used to think I could time the market and even tried some inverse ETFs but I got hammered in 2000-2001. I learned my lesson and now only invest in low-cost passive index mutual funds and ETFs. I don’t sell anything based on market conditions other than doing an annual rebalance. Even then, I try to keep my asset allocation in balance using new investment money.

  2. Nice explanation! This is something that’s always mystified me: it seems to take what’s already a speculative activity (investing in equities) and turn it into a true crap-shoot. Wouldn’t a lively game of poker be more fun?

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