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Wondering what it means when someone says they short a stock? It’s a confusing term. But a good one to know cuz shorting a stock can be a risky, yet profitable strategy.
So let’s take a look at what it means and how, like with pretty much every investing strategy, you can make or lose a king’s ransom using it.
Being short on a stock has nothing to do with the length of time you own the shares. Nor is it a stock trade made by those under 5’ 7”.
Being short on a stock is actually a bet that the stock is going to go down in price.
A long position is what most people do. They buy the stock with the hope that it will increase in value.
When you short a stock, you think the opposite. You’re betting it’s going to sink in value.
The way you short a stock is actually kind of weird.
When you buy a stock you think will go up in value, you purchase shares of that stock. You own those shares. And hold them in your investment account until you sell ‘em. That’s not how it works when shorting a stock.
When you short a stock, you don’t actually own shares of it. Instead you basically borrow shares from your broker and then sell those borrowed shares in the market.
If the stock drops in value, you can then buy those shares back at the lower price and pocket the difference when you “return” the shares to your broker.
That’s probably clear as mud so let’s look at an example to (hopefully) make this clearer…
Let’s say you think toilet paper’s days are numbered in the United States. People were so scarred from the Great Toilet Paper Shortage of 2020 that they are flocking to bidets in huge numbers. So you want to short a toilet paper company cuz you think their stock price is gonna drop.
So you go to your broker and short shares of Oohlala Toilet Paper Company (ticker symbol OCRP). Let’s say OCRP is trading at $50 per share and you short 100 shares. You “borrow” those 100 shares from your broker and then immediately sell the shares on the market and get $5,000 (100 shares @ $50 a share) for them.
Then, about a month later, Big Bidet makes its move and the price of OCRP goes into the toilet and drops to just $20 per share.
At that point, you repurchase your shares of OCRP for $2000 (100 shares @ $20 a share). Then you return the 100 shares you borrowed to your broker and you keep the $3000 difference as your profit.
Sounds awesome, right?!
Not so fast Chuckles.
There are some big risks associated with short selling. The main one being the potential for unlimited losses.
If you buy $5000 worth of a stock you’re long on, worst case scenario is you lose $5000 if it plummets to 0.
With short trading, that’s not the case. Let’s go back to our example with OCRP.
Again, let’s start with you shorting 100 shares at $50 a share. But, after you buy the shares, a news story breaks about people getting injured after being launched up off their toilet seats by bidets that have super powerful water pressure.
This sends shares of OCRP soaring to $150 a share. Now, you have to buy the shares back at a price tag of $15,000! So when you give them back to your broker, you now owe the broker $10,000.
Oh crap is right!
So with short selling, you can lose a lot more than your initial investment.
Short selling definitely has a place and can be a great investment strategy. But you gotta know what you’re doing and what the risks are. Most investors, and especially newbies, are better off avoiding short sales and sticking to less risky investing strategies.