Ahh yes, the elusive “Short Selling” is finally here. Hopefully, all your doubts from The Big Short will get cleared up in this Short Selling 101 edition of Everything Finance.
We will be discussing what is short selling with the help of an easy-to-follow Short Selling example.
So by now, I take it that you are already aware of the different types of financial instruments, including Money Market Securities and Fixed Income Securities (Zero Coupons, hello!). Not just that, we have already mastered the fundamentals of Stock Market from my previous post on Stock Market 101.
Bear in mind, short selling is a bit tricky to understand. On the surface, it might be easy but it has lots of little things that can trip you up. All that said, let’s delve straight into what Short Selling stocks look like.
Which stock should we Short Sell today?
Let’s take something that everybody is familiar with – Apple (AAPL). The Everything Finance team here at ED Times buys 100 shares of Apple at $100.
Apple then releases its quarterly financial report and announces massive earnings. Hurray, the stock bumps to $125! Naturally, we decide to jump ship and rake in all that $$$. We sell our entire Apple portfolio, earning 100*(125-100) = $2500!
Not bad.
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So that’s short selling?
Hold your horses, we are getting there. Suppose you are a skeptic (read: Apple hater) and believe that the new iPhone will flop. You expect Apple shares to go down as a result. You want to make a few bucks while you are at it. So what do you do? You never bought any Apple shares in the past because why would you? You have no faith in the company, to begin with.
So how can you game the system?
You short sell
But how?
Easy. You find some sucker who has Apple shares and you borrow them. You then sell it at the current price of $100.
Wait, how?
Let’s take a deeper look. To buy/sell shares, you need a broker. A broker is an entity that does trades on your behalf. When you tell your broker to buy 100 shares of Apple, your broker will go out and buy 100 shares and put it into your account. Notice that these shares are not with you, there are sitting with the broker in an account with your name on it.
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Still with me?
So if the Everything Finance team wants to short sell our stake in Apple, we would tell our broker to do so. We would say something like “Sell my 100 Apple shares @ $100 right now”. Our broker then goes through their system, finds another client with 100 Apple shares, “borrows” them, and sells it.
Voila, we shorted Apple.
No way!
Yup, that’s it. We end up with a whopping –100 Apple shares in our account and our broker deposits $10,000. But we are NOT done yet. Remember, we have –100 shares sitting in the account. How do we fix that? We buy shares when the price goes down.
Suppose the Apple share price plummets down to $75. To close my short position, I buy 100 shares and return it. Let’s do a quick balance.
Profit = 100* (100-75) = $2500.
We just made $2500 short selling or shorting Apple stocks.
This is how you make money with taking short positions. This right here is short selling 101.
But you took someone’s shares?
Yup. That’s the magic of short selling. You don’t need to “own” stocks to short them.
There you have it, The Big Short just became a lot clear. Hey, at least you now know what shorting a stock is. Well, a little bit anyway.
Of course, there is a lot more to short selling besides this. We will look into that in another post. Stay tuned!
Image Credits: Google Images
Sources: Moneycontrol, NPR, Financial Express
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