Shorting Stocks

Fundamentals of Market Investing by Adam J. McKee

If you want to trade the swings in stock prices, you are limited to buying low and selling high.  In the stock market, you can actually sell high and buy low.  When you use this latter method, you are said to be shorting a stock.  In theory, the way shorting works is simple.  You borrow stock from your broker and then sell it at what you believe to be a high price.  You wait until you think the stock has gone down as much as it will, and then you buy it back at the lower price.  You then give your cheap stock to your broker to replace the ones you borrowed.  You pocket the difference between what you sold it for and what it cost you to replace it.

For reasons that I don’t really understand, a lot of investors act is if shorting stocks is something that you just don’t do in polite company.  Maybe it is just mean to bet against a company like that.  The folks that run the company will not know that you sold their stock short, so it does not really hurt anybody’s feelings.  (The sum total of short interest in a stock does affect its valuation, but you are too small to be noticed).  Understanding how to short a stock is just as valuable as knowing how to buy it now and sell it later at a profit.  Either way, you make money.  The real danger comes in the rare circumstances where the stock’s price explodes higher, such as when a faltering company (why you shorted it) is bought out by a bigger, more successful company.

Let’s say you are a cell phone aficionado.  You hear the new Pear Phone 8 is out, and you buy one the day it is released.  The phone is terrible!  You hate it.  All of the online reviews on the techie websites that you follow agree that it is terrible.  The product is too new for Mr. Market to realize it is terrible, so the value of Pear stock is still high (it went up in anticipation of Pear 8’s huge sales).  You quietly sell 100 shares of the stock of Pear short at a price of $100 per share (Your account is credited with $10,000, but you owe your broker 100 shares of Pear).

After a day or two, the Wall Street Analysts start downgrading the stock, citing the poor reviews and anticipated poor sales of the new phone.  Stocks usually drop in price when an analyst downgrades them.  After the downgrades, the stock drops 3.6%.  You decide that the damage is done, so you “buy to cover” your 100 shares of Pear for a profit of $3.60 per share, or $360.00.  Not bad for a day’s work.

Let’s examine the same scenario the other way.  Let’s say Pear announces that is merging with the much bigger and more successful Peach Phone Company.  The stock soars 25% on the news (with mergers, the big company usually goes down, and the little company usually goes up).  Now the stock costs $125 per share, and that’s what you’ll have to spend to give your brokerage its stock back.  You lost $2,500.

If you are using a type of investment account that doesn’t allow shorting, one option is to buy an inverse ETF.  These ETFs are designed to perform as a mirror (reverse) image if the thing they track, so they are the equivalent of shorting the stock, commodity, or index that the fund tracks.  If you really want to roll the dice, you can also buy leveraged ETFs.  These are extremely volatile, and you are very likely to lose money.  Because of the risk, most 401(k) accounts will not let you sell stock short, nor can you invest in leveraged or inverse products.  Mutual funds don’t have such options, and many of us are limited to those types of investments.  If you decide to short a stock in your discretionary account, the least risky way to do it is probably by buying put options.

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