Today was daddy-daughter day, so I didn’t do any trading. Instead I thought I would help with a problem that often comes up for traders, how to explain short selling to civilians.
Over the last few months, whenever I am asked at a social function what I do, and I respond “I trade stocks”, I get that “look” that ranges from pity to Schadenfreude, followed by something akin to them saying “things must be pretty tough, huh?” I of course respond that I am doing fine, because I can make money when the market moves down by……………
SHORTING…..!!!! (insert glazed look in conversationalist’s eyes).
My mother actually thinks that am doing something illegal when I tell her I can make money when a stock goes down. Personally, I never had an issue with the concept of shorting, which is maybe why I am a trader, but for others who do, I have developed a simple way to explain it. It goes like this…..
A share of stock is standardized, just like a book, meaning each share of IBM is the same, just like every copy of Harry Potter and the Deathly Hallows, on the shelf at the local bookstore is the same. So let’s say your best friend just bought a brand new copy of Harry Potter, and the moment he brought it home you asked him to borrow it. Now that you have borrowed it from him, you owe him back one copy of Harry Potter. So you take the copy he loaned you, and you sell it. Maybe you sell it on Ebay, maybe at a garage sale, maybe to an individual, it doesn’t really matter. You get $25.00 for the book when you sell it. Now you still owe your friend one copy of Harry Potter, so you order a copy on-line, at a discount book wholesaler. That copy only costs you $19.95. The book arrives, and you return it to your friend, and keep the difference between what you sold it for ($25.00), and what you bought it back for ($19.95). You have thus made money by selling something you did not own, and then buying it back (and replacing it) for less that you sold it for.
Short selling is the same concept, you just replace a share of stock of XYZ company, for the copy of the Harry Potter book. In the above example, the venue you sell the book in could be various, but with the stock, it is the open market. Now if you were unable to buy the book back for the $25.00 or less that you sold it for, you would have had to cover the difference out of your own pocket, and thus lost money. The same would go for the stock example as well.
If they don’t understand the concept of short selling after this explanation, then they never will.
Thanks so much for your explanation of short selling. I’m like you mother, so am having a hard time figuring out this whole financial crisis.
One thing, though. If I borrow my friend’s book, we both agree to the deal. What I don’t get is why a company, like say IBM or (to be more relevant) HBOS would agree to let me borrow their stocks.
I’d surely appreciate it if you shed a little light on the why lend stock question for me.
Sign me,
Muddled Mom
That’s where regulation comes in, Eileen. However, there’s a debate as to whether “borrowing stocks” should be regulated to prevent short-selling.
One side of the debate says that short-selling helps the public by exposing the weakness of a publicly traded stock. To follow the analogy of the Harry Potter book, by borrowing the book and selling it to another person at $25, you can buy another book at Ebay for $15 and pocket the profit. By doing this, you are actually exposing or telling the people that Harry Potter books are only worth $15 in Ebay, not $25. Why should you regulate this activity if it redounds to a benefit by the Harry Potter-reading public?
The other side basically says that this activity is evil because it is prone to “collusion” where a group of sellers will agree to “decide” that XYZ stock, although healthy, is actually not. So you may be a retired man who invested in XYZ stock, enjoying looking at the papers and how the value of the stock is going up by the day. Then suddenly the value plummets and so does his lifetime savings. And the culprit? – collusion by these short-sellers.
The other side also says that “short-selling” is actually a selfish illegal activity conducted only for personal profit. It does not really have a positive effect on the public. The fact that the stocks that the seller sold is not theirs is a betrayal of customer trust. How would you feel if you learned that your friend short-sold the bracnd new watch he borrowed from you, and that that the watch he gave back to you has a scratch, a mechanical problem, and has the initials that do not represent your name?
I’ll let you judge for yourself.
I understand the concept of short selling, but your analogy does not equate to the shorting.
When you “borrow” the book its market value is irrelevant to the person you borrowed from.
The stock however is owned because of its market value.
Why do companies let you borrow stocks that you are going to replace with stocks made less valuable by your actions?
How do they recoup the net value lost?
thats what makes goood old brian there a crook….borrowing my a**
Nicely explained.
Makes perfect sense.
Thanks!
I have spent soooo much time reading articles about what the heck this short selling is all about. And by accident I come accross this explanation.
I have read pages of explanations and definitions and in a short story he said it all. So simple.
This guy needs to be a teacher! And he deserves big bucks.
Thanks I finally got it.
So Norm’s kind comments woke me up from a long winter’s nap. (By the way Norm, if you know any big time editors, feel free to pass my name to them, as who am I to pass up the “big bucks”….lol).
In response to comments by Eileen and K Kelly, I think you both may have a fundamental misunderstanding about how the market works. Companies have no say so in what happens to their stock once it gets into the secondary market, i.e. the stock market. They no longer own it, just like a publisher no longer owns the Harry Potter book after it is sold. The market ONLY determines what happens to that stock (regarding value).
Tim is just an idiot, probably from the “short sellers are EVIL” camp. What Tim does not understand is that short sellers help make a liquid market. They take the other side of a trade where someone wants to buy that stock. Without short sellers, stocks would be less liquid, spreads larger, and volitility increased.
Ron’s comments are a little too long and off topic to worry about.
Okay…..back to sleep.
Formerly ADD Trader
Hi, nice explanation.
Suppose if a stock price is $220 today. If I place a “short-sell” order at $270 – and if the stock price goes down to $219 and if I buy it then – in that case I make ($270 – $219 = $51) profit. Right?
But suppose if the stock price starts rising and let us say it is $221 – can I wait for some more time (in the hope that the price will go down again)? what if the price reaches $250? how much money I loose? is it ($270 – $250 = 30)?
ideaunique,
If your example is correct then I get the concept. Cool! Thanks Merry Christmas and a short selling and profitable New year.
Why dont you clever Yanks do something useful ? why not make something mechanical that is useful to others and makes you money also ? Its time you stopped screwing up the world for everyone else !!!
That is the BEST, FUNNIEST, explanation EVER! I actually forwarded this article to my Finance Professor!
I have also attempted to explain this to people, without much success. The few who did grasp the concept were apathetic about it. There would be nothing wrong with short selling if no one manipulated the market. The problem comes when there is collusion to drive the price of a stock down in order to profit it from it. If you think this is “impossible” try this to see for yourself. Pick a stock that is trading very slowly and is cheap, offer a small profit on a minimum number of shares and watch the price change to match when they are purchased. The same thing happens when you go a little lower. If that doesn’t happen quickly ask a friend or two to make even lower offers on the stock. The sheep will see it as a trend and start to unload in fear of even greater drops in price. Now imagine this being done on a wide spread basis by the “BIG DOGS” on larger more heavily traded stocks. Kind of explains drops in price on stocks showing nothing but good news.