Short Selling?

Short Selling

You might hear the any one of the following phrases following a company’s earnings report, or more likely, before they have announced their current earnings: “I’m short the stock,” “This is short opportunity,” or, “The short interest is high.” And no, none of these have anything to do with the height of the investors in the company, so what does it mean? More importantly, what does it mean for you?

What short selling basically is, is the following:

1) You do your research and feel that a particular firm’s stock price will be heading lower in the near term.
2) Calling your broker, you ask to “short” let’s say, 100 shares.
a. This means that your broker loans you the shares, which you then sell and pocket the money
3) If your research pans out, the stock price of the firm will drop, which enables you to buy them back at a lower price than you sold them at.
a. Buying the shares back, you return them to broker, and keep the residual profits.

Keep in mind that, since you did not ever own the borrowed shares, you owe back to the broker any dividends that were paid out that would have been applicable to the shares. Additionally, your broker will not wait forever for your strategy to work itself out, so there is a clock ticking in the background of every shorting strategy.

Also, sometimes there is something known as a “short squeeze.” What this means is that, for some reason, instead of dropping the price of the stock increases. Scrambling to limit your losses, you try to buy back the number of shares you owe to your broker; unfortunately, depending on the amount of short-sellers that had bet on the stock dropping, it could be you and a lot of other people buying the stock. The law of supply and demand takes over and the price increases, which further panics any remaining short sellers – I have attached a graphical representation of the VW short squeeze of 2008. If you are a long-term shareholder in a firm that is undergoing a “short battle,” it can create a lot of volatility that is unrelated to the operations of the firm, but usually the long-term fundamentals win out over short-term volatility in the long-term.

Shorting stocks and participating in a short squeeze “rally” are both speculative ventures that require a great deal of knowledge, deep pockets, and a high tolerance for risk. Always consult a financial services professional before entering into any “short” strategy.

I have a link below from investopedia.com that has an amazing video giving a great tutorial on how short selling works. In addition there is a graph that gives a great illustration of what happens during a “short squeeze.”

http://www.investopedia.com/terms/s/shortselling.asp

http://www.reuters.com/article/2008/10/28/us-volkswagen-idUSTRE49R3I920081028

http://seekingalpha.com/article/291188-tesla-the-looming-short-squeeze – graph