When you make a decision to act upon a stock, you are “Taking a Position.” There are two kinds of positions you can take:
1. A Long or
2. A Short Position
Taking a long position means buying the stock based on the belief that the price will rise, therefore taking a long, or bullish position.
The short position is a little more complicated. In shorting you sell the stocks and then buy them back when the price falls, earning you a profit.
If you don’t own shares of XYZ stock but you ask your broker to sell short 100 shares of XYZ you have committed shorting.
In broker’s lingo, you have established a short position in XYZ of 100 shares. Or, to really confuse the language, you hold 100 shares of XYZ short.
Why would you want to short?
Because you believe the price of that stock will go down, and you can soon buy it back at a lower price than you sold it at.
The short sale of stock is a bet that the price of that stock will decline.
Here are the mechanics:
You decide that XYZ at a price of 110 is at or near its peak. You feel that XYZ will decline in price from this level. So you want to short the stock.
You tell your broker you want to short 100 shares of XYZ at 110. You borrow from your broker 100 shares of XYZ at 110 and sell it to someone else.
This is the nature of the short sale. You’re selling something which you borrowed. Again, you borrowed 100 shares of XYZ at 110 and sold it to someone else.
You actually borrowed the 100 shares of XYZ from your stockbroker. He either has it in inventory or he borrowed it from a client or another brokerage firm. Either way, it is your broker who loans you the stock to sell to someone else.
So now what happens?
Hopefully, the price of XYZ goes down for you. Let’s say that XYZ declines to 85. At 85, you decide that XYZ may not decline much further, if at all.
So you want to take your profits. How do you do that?
You now buy 100 shares of XYZ at 85 and pay your broker back the 100 shares of XYZ. You borrowed the stock at 110 and paid it back at 85.
You made 25 per share in profit or 2,500. You sold the borrowed stock for 11,000 and bought it back for 8,500.
Conversely, suppose the price of XYZ goes up to 125. You would have sold the stock for 11,000 and now want to get out of the position.
You would now have to go into the market and buy 100 shares of XYZ for 12,500. You would then be returning the loaned stock at 12,500. In this case, you have a loss of 1,250.
Some points of common sense:
If a stock you shorted begins to appreciate to a level approaching your account equity, or when it looks as if you will be unable to repurchase the shares in the open market given your current account value, your broker may force the short position to be covered, that is he can call the loan, forcing you to repurchase the stock at a loss in order to deliver the borrowed shares.
Also keep in mind that when you short a stock your downside is theoretically unlimited because a stock might continue to go up and up … and up!
This differs from a typical long investment where an equity holder’s downside risk is merely his principal.
Shorting a stock is often a solid strategy for making great gains or hedging a portfolio. However, the risks for individual investors are very real.
Commissions, rising equity prices, and time are all hurdles that could limit an investor’s ability to generate meaningful profits through short-selling.