Selling short
Also known as
short selling, is the practice of selling a
security that the
investor does not own.
This curious practice is intended to allow the astutue investor to
profit on the
depreciation in price of a companys
stock price.
It works as follows :
Consider a
programmer who suspects that IBM's shares are wildly
over valued. Note that she
does not own any IBM stock at all.
She
shorts IBM shares, or sells them at the current
market price, say $100 a share. She receives $100 in
cash for every share she sold. She can do
whatever she likes with this
cash, since it is her money from this point on.
Meanwhile, on the
other side of the
transaction,
someone has bought the IBM shares that she sold.
To deliver these
securities to the
purchaser, her
brokerage firm will
borrow IBM stock from the
dormant holdings of an
institutional investor.
Institutional investors are defined as the large
pension and
mutual funds, who typically will
buy and hold shares for long periods of time. By participating in
short selling this class of investor is able to earn
additional fees from their shares.
Note that the programmer has effectively borrowed something - in this case, IBM stock - and sold it. For this
privledge she must, of course, compensate the real owner.
She pays
interest to the institutional investor in the form of a small fee, which is known as
the broker call rate.
Someday, however, she must close out the
position and return what she has
borrowed. To do this, she must acquire IBM shares in the
open market.
To complete this example, assume that IBM sharply drops to $30 a share. The lucky programmer purchases it at this price, and repays her loan from the institional investor; this is called
closing out a short position
The difference, $100 - $30 = $70 is her
gross profit per share sold.
She must also, of course, include any interest and brokerage fees that she paid to determine her
net profit.
Short selling is clearly a very
risky trading strategy. If IBM had gone to $200 a share, the programmer would have
lost $200 - $100 = $100
A SHARE.