Stocks: Understanding stock shorting – making money when a stock price goes down

Stock shorting is big in the news these days:
There are many news articles being printed these days about stock shorting. Also, Congress and others are looking at stock shorting and considering various new regulations on this investment tool. Many sophisticated and accredited investors use this means of investing to make a lot of money when the price of stocks move down. I hope to help better explain what stock shorting is, how it works, how it can work against you, and what the benefits and issues are with it.

What is stock shorting?
Most investors are familiar with investing “long” by holding a stock while it hopefully increases in value over time. The goal is for the stock price to continue increasing so there will eventually be a good profit (capital gains) when the stock is sold. However, sophisticated investors make money when the price of a stock goes down. This type of investing can be done by shorting the stock.

How can you make money when the stock price goes down?
As mentioned above - in the case of “going long” a stock, the investor purchases a stock and sells it on a future date hopefully at a higher price. The difference between the purchase and sales price (if sold at a higher price) is then the profit. In the case of “shorting a stock”, the investor borrows stock from someone else and immediately sells it on the market. Eventually the investor buys back the stock from the market - hopefully at a lower price than when it was previously sold by the investor - to give it back to whoever lent the original stock to sell. This is the opposite of going long. The investor first sells the stock at a high price and later buys back the stock at a lower price. The investor keeps the difference.

An ideal example showing how shorting works:
For this example, I’ll assume my broker does not charge to buy or sell stocks so those costs will not be included. Also, I am not going to talk about the broker’s margin requirement. This is a simplified example (as will be the other examples in this article).

On Monday September 15, 2008 I tell my broker to short 100 shares of Morgan Stanley stock (symbol MS). The broker finds 100 shares from someone to let me borrow and then sells them on the market. Assume all the stock shares sold at $34.00 for a total income to me of $34 x 100 = $3,400. Further assume I am a genius investor and happen to know the bottom of the price would be Thursday September 18 at $11.92 and tell my broker to buy back the 100 shares of MS. If I was lucky enough to get all 100 shares for $11.92 then I spent $11.92 x 100 shares or $1,192. The shares are given back to whoever lent me the original 100 shares and I pocket the difference of what I sold the stock for ($3,400) and what I paid to get them back ($1.192). In this case, I would make a profit of $2,208 ($3,400 - $1.192 = $2,208) in only four days without even owning the stock. Furthermore, I didn’t need money to buy the stock since the money was received when I initially sold the borrowed shares.

Where shorting can work against you:
First consider how you lose money when going long a stock. When going long, you lose if the price of the stock goes down. The stock was first bought at a higher price than when you eventually sell the stock with the difference being your loss. In the case of shorting a stock, you lose money if the price of the stock goes up. The stock was first sold at a lower price than when you eventually buy the stock back with the difference being your loss.

An example of how shorting can work against you:
Lets assume the opposite situation for MS than the above example. On Thursday September 19 I think MS is going to continue going lower and tell my broker to short 100 shares. Assuming the broker finds 100 available shares and sells them at the low $11.92 per share, I receive $1,192 at that time ($11.92 x 100 = $1,192). However, instead of continuing lower, the news announcement comes out that the government is working on creating an entity that will take all of the bad assets off of the financial institution books. The stock starts climbing very rapidly. On Friday I panic and tell my broker to buy back the 100 shares. At the time I am forced to buy the shares at a high price of $33.25 since many other short sellers are also quickly buying back shares of stocks to “cover their short”. I then pay $3,325 for these 100 shares ($33.25 x 100 = $3,325). The net result is that I lose the difference or $2,133 in less than 24 hours!

What is a naked short?
You hear a lot about naked shorts these days. In this case, the investor does not first make sure there are 100 shares of stocks available to sell or to buy back and sells the stock anyway. This can be hard to understand, so I refer you to a article on Wikipedia that goes into more detail.

Why is shorting allowed?
Shorting can be beneficial to a stock by helping curtail over-buying of a stock to the point of ridiculous prices above what the underlying company should be valued at. By shorting stocks that have run up in price, these investors can help bring the price back down to more reasonable levels. Therefore, shorting does play a beneficial role of helping to regulate the price of stocks that may otherwise reach very high levels and fall precipitously when the buyers dry up. The “long” investors would then be hurt very quickly as the price drops. By allowing shorting of the stock, hopefully it does not reach such a high level where the risk of dramatic fall is high. If the shorts bring the price too low, then eventually the “long” buyers start coming in to bring the price back up to a reasonable level. The cycle then repeats if the price again goes up too high to where the short sellers get the upper hand to bring the price back down.

How the current freeze on shorting financial stocks might hurt investors:
Currently there is a freeze on shorting many of the financial stocks due to the major financial crisis in our country. This is good in one way since it stops the runaway shorting of a stock where the price goes down and more shorts join in. As they join in the price drops even more attracting additional short sellers. The result is a compounding of shorts that overpower any attempts by the “long” investors to bring the prices back up. Also, many of these financial companies are good. The price drops are not in line with the actual strength of the underlying company, but are the result of these compounding shorts. So, the freeze allows this short upon short upon short to stop, hopefully letting the stock have a chance to rise back in a range reasonable for financial strength of the underlying company.

The danger here is that the price of these stocks could go the other way and be much higher than what is reasonable for the underlying company. Without short sellers to help regulate and bring the prices back down to reasonable levels, these stocks could be in for a dramatic fall at some future point when the “long” investors have all bought what they want. At that time, they start to sell in panic if the price drops. They want to get out at the high and not be caught in a rapidly declining price again. So, we will have to see if the prices of these stocks stop at reasonable levels on their own as they recover from this period of extremely heavy shorting or if they will get too high and be in for another round of rapid decline, even without short sellers. When the ban on shorting is eventually lifted, the short sellers will hit companies where the prices of the stocks have gone way too high. The drops could start a panic sale again as “longs” get out.

Summary:
Stock shorting is a legitimate means of investing and plays an important role in helping keep stock prices regulated. Many times, it helps prevent “bubbles” where prices go way to high and fall precipitously as the “long” investors panic out. Stock shorting is not well understood, but is definitely a tool used by some accredited investors, sophisticated investors, and other seasoned investors.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content