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 go 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’re short, you actually borrow the shares via your brokerage, and then immediately sell
them at market price. The proceeds from the sale 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.
A little example. You borrow one share at $10 and sell it. The $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 pocket the $3. Situation
two: 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 can 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. In the example before,
you bought it for $10, the business fails, and shares go to $0, you lose your $10.
But on the flip side, if the business does 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 the price of a stock. Say you were short,
and the stock tripled. You gained $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. Generally, there is a stock loan fee associated with shorting. It’s stated as a
percentage and you’re basically paying it daily, so every day that 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 of events like Brexit and 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 positions, 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. Lastly, you’re on the hook for
dividends paid out while the shares are on loan. 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 shorts can also be a good check on irrational exuberance. But generally,
the average investor should stay away from shorting. It’s risky and complicated. Hopefully this
video made it a little less complicated. Thanks for watching, guys! If you enjoyed
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