When you buy a stock, you're hoping that the value will go up over time. If you're short a stock, you're expecting the opposite: that the value of the company will go down in the future.
While the motivations might be simple, short-selling a stock is complicated and risky for the average investor. We made this video to try and make it a little less complicated.
A full transcript follows the video.
Dylan Lewis: Hi! I'm fool.com editor Dylan Lewis and on this episode of FAQ we're going to go through the long and short of shorting stocks.
When you buy a stock, you're hoping that the value will grow up over time. When you're shorting a stock, you're expecting the opposite, that the value of the company will go down in the future.
Buying a stock is simple. You have money in your account, you buy it, it's yours. Shorting is a little more complicated. When you short, you actually borrow the shares via your brokerage and then immediately sell it at market price. The proceeds from the sell get deposited into your account and you have an open short position. To close this position, you have to go out and buy shares and return the same number of shares to the person you borrowed them from.
So, a little example: you borrow one share at $10 and sell it. $10 is deposited into your margin account. Let's walk through two different scenarios one month later. Shares are at $7. You buy a share and return it to your brokerage and pack it the $3. Situation No. 2, shares are at $13. You'll probably get a call from your brokerage asking you to put more money in your margin account to cover the losses. You could either commit to the position and put that money there, or buy shares at market price, close out the position and eat the $3 loss.
Shorting is a lot riskier than buying stocks, and the main reason for that: the upside and downside are flipped. When you own a stock, the worst case scenario is that you lose all of your money. So, in the example before, you brought it for $10, your business fails and shares go to zero, you lose your $10. But on the flip side, the business go well over time, the stock could double or triple, earning you more than you originally invested.
When you're short, it's the opposite. The most you can gain is 100% of your money back, but you could lose more than you originally invested, because there's no theoretical limit on a price of a stock. Say you're short and the stock tripled; you gain $10 by selling it after you borrowed it. But you now have to go out there and buy it back for $30, meaning that you're taking a $20 loss.
There are some other downsides to being short. You have to pay to watch your thesis play out. So, generally there is a stock loan fee associated with shorting. It's stated as a percentage, and you're basically paying it daily. So, everyday you have the position open, it eats into your returns. You have massive downside with big earnings surprises, M&A activity, or Black Swan-type events like Brexit in the U.S. election results as well.
When unexpected events like those happen, shares can spike, as people that are short panic to cover their possessions, and this is called a "short squeeze".
With shorting you're also betting against the general motion of the market. Historically, the U.S. stock market has returned 6% to 7% annualized. Going short is a bet against that general growth trend. And lastly, you're on a hook for dividends paid out while the shares are on low.
As a market tool, shorting is a good thing, allowing people to bet against companies, creates an incentive for people to identify fraud. And the short can also be a good check on a rational exuberance. But generally, the average investor should stay away from shorting. It's risky and complicated. Hopefully, this video make it a little less complicated!
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