This week I have seen numerous videos and read multiple posts where people are struggling to describe a ‘short’. In stock market terminology, what is a short?
Some Basics
People understand the process of investing in a company stock to mean an investors money is exchanged for a share or interest in a company. The share is held by the investor, with time and good performance of the company, the value of the stock increases as the value of the underlying company increases. In stock market terminology this is referred to as a ‘long position’.
This implies a factor of time, and certain types of investment strategy such as value investing, the investor carefully selects which companies meet investment criteria and holds stock in these companies to benefit from the ongoing long-term growth of that company. The investor is rewarded for providing capital for the companies use.
Markets gain and lose value, economies rise and fall, companies appear and disappear. Investors expect to earn returns on capital that is invested in these markets. This drives investor behavior and creates trades that are much different than a basic long position.
The Physical Short Sell
For our purposes today we will discuss ‘physical short sell’ by following an example. We will use GameStop Corporation (GME).
We, the investor, have been evaluating stock for consideration in our portfolio. We have found GME and in our evaluation determine that the financial position of the company is poor, they are reporting losses and entering a third quarter of negative earnings per share which is forecast to continue over the long-term. GME stock is currently trading at $39 per share and our evaluation determines that the underlying business only represents a value of $5.10 per share. We determine that this stock market price will drop as other investors also realize the stock is heavily overvalued.
Instead of walking away to find a sound investment for our portfolio we decide our evaluation is so strong that we are certain this stock will drop in value soon. We decide to position to profit from the decline in GME stock value. We are going to short this stock.
We do not own any shares in GME.
To create our short position, we first locate a broker who holds GME stock. We garner a deal with the broker where 25,641 shares of GME stock is loaned to us. To loan us this stock the broker will receive a 10% fee.
We receive and immediately sell 25,641 shares of GME stock at $39 per share receiving $1M in cash, 10% or $100,000 is owed to our broker and paid. We now hold $900,000 in cash and still owe our broker 25,641 shares of GME stock.
After a week of holding the stock, the market adjusts, and GME is now trading at $17.34 per share, continuing to lose value. We buy 25,641 shares of GME at an average price of $17 per share. We pay $435,897 for 25,641 shares and return all borrowed shares to the broker.
From our short position in GME we realize a gain of $464,103. Our broker is extremely pleased to have the 25,641 shares returned to them and for receiving their $100,000 fee. They ask that we return to do business again soon. The broker jokes that the shares were on deposit from a local company’s pension fund, they didn’t own any shares either.
A short seller positions to profit when a stock performs poorly, it is often viewed as unethical, and has been at the root of many stock market crashes and corporate bailouts in recent years. Short selling may have originated in the Netherlands in the 1600’s and is common in today’s markets including money, equity, gold and silver markets. Short selling is viewed as being critical for institutional investors hedging bets when trading stock.
The Punchline
These institutions are backed by large firms, governments, and tax dollars.
“Learn every day, but especially from the experiences of others. It’s cheaper!”
– John Bogle
Did you enjoy this post? Related content can be found found here.
And Finally additional content can be discovered on our Youtube channel.
