Shorting a Stock, Do I have it right?
Hi,
A few months ago me (the 18 year old high school student) and Kevin (Princeton Undergrad) got into a discussion about the logistics of shorting stocks. Many know the basics of going short; to essentially gain from a company's loss. However the details are quite vague and even difficult to find on the web.
So here is my explanation of shorting: An investor borrows a stock from a broker at 40 dollars/share and promises to pay it back at the current market price. After borrowing the investor immediately sells the borrowed share to a third party for the same price. Now the investor has 40 dollars in cash and owes the broker what ever the price of the stock is when he decides to pay the broker back. If the stock falls to 15/share then the investor can pay the broker back the 15 dollars (current market price) and keep the difference 40-15= 25 dollars profit. OR if the stock rises to 50/share the investor will owe the broker 50 dollars: 40 coming from selling the share to the third party and an additional 10 out of pocket= 10 dollar loss.
This seems to be the only that makes sense. Is this right?
Thanks,
Chaffey
Yes, generally, that is correct. Remember, however, that you have a carrying cost incurred when you borrow that stock to sell it since you are paying interest back to whomever let you borrow it. But generally you are correct in so far as the mechanics of shorting a stock.
Suppose I were to short a stock on a trading platform like Etrade or TDAmeritrade? I dont actually do any of this middle man shit myself. Does etrade itself arrange a third party to go long on my borrowed stock?
I will give you a quick rundown on how it works for a retail account. Remember you need to be approved for margin as you are essentially borrowing money (shares).
You sell 10 shares at 10 dollars a piece to fidelity all in all you get 100 dollars. There are three ways the transaction can go.
Stock decreases to 5 dollars - You buy 10 shares at 5 dollars and then give the shares to fidelity. All in all you gain 100-50-Interest Fidelity Charges and transaction fees. Note: When the stock has a steep drop like this to 5 dollars everyone who shorted the stock will be buying shares to cover their short which will cause the price to increase in the short term. This is why a stock usually rebounds a couple percentage points after steep drop.
The price of the stock increases up to a point where fidelity essntially says you have to pay them back plus interest.
Company goes bankrupt and you get to keep the 100 dollars.
Yeah, you're going to have to post up an ad on kijiji or craigslist and meet with the third party in person.
What are the carrying costs like? Is it quoted as a % of the stock price (when borrowed or when returned?) or a flat fee?
There is also naked shorting, where the same arrangement happens except the investor/borrower has no idea if there are shares available to borrow in the first place.
The borrow cost would be quoted as a percentage of the stock price at a given time, and will change as supply/demand changes.
I think you technically owe the broker the share back, not the current price of the share. In most cases there is no difference but the need to put your hands on a share, if only for a moment, can create a "short squeeze".
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