Short Selling

The Big Short

What is short selling?

“Buy low and sell high” is a popular phrase used in investing. Shorting is the opposite. It’s the sale of a security with the expectation that its value will fall in the future. If the price falls, the seller can then buy it back at a lower price and make a profit.

A short is therefore a bet that a security will decrease in value.

How it works

  • The short seller borrows the stock from someone else so that they can sell it.
  • The short seller agrees to return the borrowed stock on a specific date in the future.
  • The short seller then sells the stock on the market.
  • When the specific date comes up, the short seller must return the stock that was borrowed.
  • The short seller then buys that stock on the market at its new price.
  • The goal for the short seller is for the price to drop and make a profit. If the price goes up for the stock, the short seller must pay the difference.

For example, if a trader thinks that Apple’s stock, which is trading at $50, will decline in price, he can borrow 100 shares and then sell them. Since the trader sold something that he did not have in the first place, he is “short” 100 shares of Apple. A few weeks later, however, when Apple’s stock falls to $30, the trader can buy 100 shares of it and gain a profit of $2,000.

short-selling

Downsides

The amount of money that you can lose from short selling is essentially unlimited. When buying regular stocks, the most that you can lose is the amount you initially invested. With short selling, however, you are required to buy back the stocks you borrowed no matter how high (or low) the price. If the price skyrockets, you will have to buy back the stocks at the inflated price.


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The big short

In this 2015 movie, based on a book by Michael Lewis, a quirky, Birkenstock-wearing hedge-fund manager named Michael Berry “shorts” the housing market. He believes that the housing bubble is going to burst in a big way. He puts more than $1 billion into complex products (credit default swaps). Eventually, his predictions are proven correct, and he makes a fortune for himself and investors. The reason it is called The “Big” short is because

  • Berry convinced the banks to create products that did not exist at the time.
  • He made a fortune by taking advantage of the housing collapse that would result in millions of Americans losing their homes.

Fun facts:

  • In 1992, billionaire investor George Soros “shorted” the British pound by risking $10 billion that the value of the currency would fall. He was right, and in a single day made a profit of $1 billion.
  • During the Wall Street Crash of 1929, short sellers drove a plunging market even further downward. As a result, a rule was put into place that only allowed short selling if the last change in a stock’s price was positive. This is known as the “Uptick Rule.”

 

References

  1. http://www.investopedia.com/terms/s/shortselling.asp
  2. http://www.dailyfinance.com/2014/01/13/how-to-sell-stocks-short-risks/
  3. http://cdn.moneymorning.com/files/2014/09/20140930-tips-for-short-selling.png (image)
  4. http://www.contracts-for-difference.com/Famous-short-sells.html

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