I’m not obsessed with the stock market. I don’t read about it very much, or have any great interest in it. My financial passions lie more in budgeting, debt elimination, and the psychology behind money. How people spend their money and why. That said, I think it’s important to have be familiar with the concept of stocks and investing. Knowing the stock market lingo lets you pick up little pieces of information along the way. It also makes the whole world of investing less mysterious, and therefore less scary.
Ever hear the term to “short a stock” and wonder what that means? To short a stock means that you sell the stock before you buy it. What?! I know, it’s weird. To make money in the stock market you buy low and sell high. You’ve heard that right? Well, you don’t have to do it in that order. If you think a stock price is going to fall you can sell it first, and then buy it later.
Think of ebay. You sell something on ebay, the buyer pays, and then you ship it. Now, you don’t HAVE to have the item on hand when you list it. Let’s say that you are selling a cell phone. You heard that a new version of that phone is coming out next week and you think the current model is going to be marked down because of this. So you decide to sell the current model on ebay for today’s price of $100. You sell it on Friday. On Monday the new version comes out and the current model is marked down to $75. You go to the store, buy it for $75 and send it off to the person who bought it on Friday for $100. You just shorted that cell phone and made $25.
The risk is of course that your bet doesn’t pay off. What if the price doesn’t go down? You don’t make any money at all. Or worse,the price goes up. Let’s say that over the weekend the reviews of the new phone are all horrible (so naturally we’re not talking about a Republic Wireless phone). So horrible in fact that it makes the current model even more desirable. People rush to the store to buy the current model because they aren’t going to be made anymore and if you want one now is the only time to get it. So on Monday you have to pay $125 for the phone. You just lost $25.
Shorting a stock is very risky because you have an unlimited amount of potential loss. When you sell the item first you have to buy it at a later date. If the price skyrockets you could lose a lot of money. When you buy a stock the absolute worst case scenario is it goes to $0, but a stock’s price could go as high as it wants so there is infinitely more risk in shorting stocks than in buying them.
Let’s say over the weekend there was a government ban of manufacturing cell phones. The phones in the store are the last of the cell phones in the world. Now what’s the price? What if you get to the store and the price of that phone is $1,000. You have to pay it. You just lost $900. What if instead of selling one phone on ebay you had sold 10, or 100. Or the price goes to $2,000, or $10,000. You can see how this could mean huge losses very quickly.
When you buy a stock your losses are limited to your investment. The buyer of the cell phone in our example invested $100. The worst case scenario for him is that the price of that phone goes to zero. If that happens he lost $100. He can’t lose more than that. Where as the you, the short seller, could lose anything.
In real life stock selling you obviously can’t wait for the weekend to pass buy the stock you sold. When a someone buys a stock they own it right then, they don’t have to wait for shipping. So what you do is borrow the stock from a broker. The broker sends the stock along and you owe the broker that stock. Think of it like borrowing the cell phone you sold on ebay from a friend, you then owe that friend his cell phone back. This is called buying on margin.
When you have made enough money, or lost enough money, you buy the stock and repay the broker. This is called closing (or covering) your short.
Now you know what it means when you hear that someone “shorted a stock”, and really why you shouldn’t do it unless you are a very savvy investor.