One of the great glories of our stock, commodities, and certain other markets is being able to make money by wagering that a stock or a commodity (or something else too exotic to think of right now) will go down. Yes, you can make money by selling short a stock or virtually anything else.
Here, in a simplified way, is how it works.
You go to your broker. You tell her you want to sell your stock in that new social media site short because you have a feeling in your fingertips that it’s going down.
So, let’s say you want to sell 1,000 shares short when the stock is trading at $15 per share. The broker “borrows” 1,000 shares of the stock from my account or someone else’s account and sells it at $15, for a total proceeds of $15,000 (less fees).
That $15,000 appears as both a credit and a liability on your books. Yes, you have the $15,000. But you also have the legal obligation to repay the 1,000 shares to the other client’s account within a set time. In the meantime, you pay interest to the broker for the borrowing of the stock.
Suppose your brilliant intuition about the stock is correct and it goes down to $5 per share. You then tell your broker to buy 1,000 shares for you. You buy the shares for a total of $5,000. You return the shares to their original owner (who probably had no idea they were gone in the first place). You have a profit of $10,000—the $15,000 you originally got for selling the stock you borrowed less the $5,000 you paid to replace it. Pretty nice day’s work.
There are all kinds of fun variations on this theme. You can buy a “put” option, which allows you to sell the stock back to the brokerage for $15 per share, no matter what you paid for it, at any time during a long or short duration. That also allows you to profit from a downturn in the stock since you might be able to buy it at lower than the “put” price and make money on the difference.
You can buy an option on a put, which is self-explanatory, but also allows you to make money if the stock goes down. The beauty of a put (or an option on a put) is that it limits your risk, but we will get to that in a moment.
In fact, short sales, puts, options on puts, and similar but far more complex entities are used by the big boys on the Street to hedge their bets. If they make huge long buys on a security of an ETF or an index, they might also do some short selling or put buying or options on put buying to offset their losses if the stocks go in the wrong direction.
I know this sounds too good to be true, but there is just one big problem, one spectacularly great way to help ruin your portfolio. You can lose money on a short sale. In fact, on a true short sale, your possibilities of losing money are limitless. (Again, that’s the appeal of the option.)
On the buy of a stock or commodity or bond, your loss is limited to the amount you have paid for that stock, commodity, or bond. You cannot lose more than you paid for it. Even if it goes to zero, you cannot lose more than you paid.
But with a short sale, you can lose a vast amount beyond what you paid. You can lose the entire difference between what you borrowed the stock for and the price you have to pay to replace it.
Just for example, suppose you believe that the new social media stock is priced at $15 but is going to $5. You sell short 10,000 shares. If your hunch is right and the stock goes down to $5, you have made 10,000 × $10, or 100,000 smackers. But suppose you go away on vacation and while you are gone, the stock corporation comes up with a new gizmo that allows you to plug it into your brain and become as smart as Al Gore. Then the stock goes to $100.
You hear on CNBC that the next move for this company is an app that allows you to plug it into your brain and lose weight. You hear the stock is headed for $200. Naturally, you want out. So you have to cover your short. You have to go into the market and buy 10,000 shares at $100 to cover your short position, lest you lose even more on your short. That costs you a cool million. Now, to be fair, you also got paid $15,000 when you sold short. But still, your loss is $985,000. That hurts.
Now let’s be fair again. Rarely does a stock shoot up from $15 to $100 in a short time. But the example illustrates the problem. Your loss is measured by how far above the sale price you have to buy in. There is literally no limit on how high a stock or a commodity can go. There is no limit on how big your loss can be.
Out of such a problem are sleepless nights and forced sales of your residence made.
But, you will say, you just told me that the big boys on the Street use short sales. How come they do it if it’s so dangerous?
BECAUSE THEY ARE THE BIG BOYS. Usually, they are playing with other people’s money. Usually they hedge even the hedges. They have split-second alert systems and can sell very fast. They don’t go on vacations when they have open positions.
I have a super-smart friend named Jim Rogers. He can and does sell short. He makes money at it. I would not dream of it. Why? Because he’s big enough, tough enough, experienced enough, and quick enough to do it right. I’m not.
Neither are you.
But don’t let that stop you.
Just as I told you that you could ruin your portfolio by trying the devices the big guys use in buying forestland, going into private equity, and greenmailing corporations, so you might as well try the big-boy play of selling short. Hey, it’s only money.