The (Very) Basics of Short Selling

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

First, the typical way people think of trading is to buy first, which is called going long, and then to sell at some later time. The profit or loss is the difference between the two prices. Obviously, when you go long you expect the price to rise in the future. Shorting is just the same thing in reverse -- instead of buying first, you sell first (go short) and then buy back later, preferably at a lower price. Again, the profit or loss is the difference between the two prices. The natural question here is "How do you sell something that you don't have?" The answer is that you borrow it.

The process works like this. Let's say I want to short 100 shares of Microsft (MSFT). First I have to find 100 shares to borrow. I simply check with my broker to see if there are shares available to be borrowed. If there are none then I'm out of luck. If there are shares to borrow then I can short the stock. I can enter an order to sell 100 shares of MSFT short and once that order is filled I owe my broker 100 shares of MSFT. I'll need to buy 100 shares of MSFT at some later time, hopefully at a lower price, in order to replace the borrowed shares and close out (cover) my short position.

Make sense? Here's an example that many of you may be familiar with and may not even know it. For years after I first saw the movie 'Trading Places' (buy from Amazon.com) I never understood how Billy Ray (Eddie Murphy) and Louis Winthorpe III (Dan Aykroyd) made all that money at the end of the movie. It wasn't until I learned about short selling that I understood how they did it. Here's how it went down:

• Billy Ray and Winthorpe intercepted the Duke brothers' copy of the real orange juice crop report. They discovered that the crop was good, which would be bad for OJ prices.
• Next they gave a fake crop report to the Duke brothers, who were planning to make a killing off of their stolen report. The brothers, after seeing the fake report, were under the wrong assumption that the crop was bad and thus OJ prices had to rise significantly.
• The Dukes sent their trader into the pit to buy all the OJ he could -- price be damned.
• Billy Ray and Winthorpe stood and waited for the crowd to bid the price of OJ up so that they could short OJ to all the frenzied buyers. They shorted all the OJ they could just before the real crop report was to be read.
• Once the real report was read and the world learned that it was a bumper crop, the price of OJ tanked.
• Billy Ray and Winthorpe waited for the bottom to fall out and then proceed to to cover their OJ position and made a fortune.

See, wasn't that simple?

There are some important things to keep in mind about shorting that differ from going long. When you go long you can only lose 100% of your (assuming no margin) initial stake and your profits are theoritically infinite. Well the opposite is true for shorting -- your profit maxes out at 100% and your theoretical losses are infinite. Of course in practice your broker will close you out long before you reach infinity. :-) Nonetheless, you can see that you may not want to short stocks that are prone to big jumps (thinly traded stocks, small biotech or drug companies, mania stocks, etc.).

There's certainly more that can be said on this topic but since this is supposed to be very basic I'm going to stop here. Below are some links for more information:

• Short Selling: Introduction [PDF/Printer-friendly version]


• What’s Wrong With Short-Selling?


• Short Selling is American