Shorting a stock is a financial investment strategy that seeks to capitalize on the anticipated decline of a stock. Widely publicized as a moneymaking maneuver after the housing bubble collapse of 2008, stock shorting is a way of betting against the stock you just bought.
What is Short Selling of Stocks?
Short-selling of stocks is a three-step process that allows the seller to profit from a decline in the stock's value. Shorting stocks is a practice engaged in by arbitragers and hedge fund managers as well as individual investors who want to take a risk on what could also be a financially detrimental decision.
In practice, shorting a stock involves approaching a broker and asking to borrow shares from his or one of his client's portfolios. This means that the borrower is required to return the shares of stock at a later time, plus any dividends the stock may have earned in their time absent from the owner's portfolio. The borrower then sells the stocks on the open market and pockets the cash. Later, when the stock's share prices drop, which is what the borrower had anticipated, he buys the stocks back at this newer, lower price and returns them to the original owner. This allows the borrower to pocket the difference in price between what he sold the stocks for initially, and what he's paying to buy them back now. This is how stock shorting can be a profitable undertaking.
How to Short a Stock
The process of shorting a stock is as follows:
- A buyer, anticipating a decline in the value of a particular stock will make arrangements to borrow a certain amount of shares. This arrangement is typically made through a broker whose firm will facilitate the acquisition of the stocks. This typically requires a lending fee or promise of an interest payment.
- The buyer immediately sells the shares he has borrowed on the open market, keeping the cash.
- When the stock falls, the buyer then buys the stock back at the new, low price, pocketing the difference between what he sold it for and what he had to pay to reacquire the stocks.
- The stocks are then returned to the lender with the buyer keeping the profits.
What Is An Example of Shorting a Stock?
An example of shorting a stock is if a trader named Dennis had a feeling that Disney's stock was about to take a nosedive following some gossip around shady accounting practices, he might decide that the stock is worth short-selling.
Dennis would then go to a broker or brokerage firm, and ask to borrow some Disney stock. Brokerage houses often get a fee for lending stock which makes the practice lucrative for them, increasing their inclination to lend stock. Dennis's broker contact agrees and loans him 50 shares which have the current selling price of $100 each.
Dennis then sells the shares on the open market for $5,000. Three weeks later, as Dennis predicted, Disney's stocks take a sharp fall. The stock is now worth only $25 a share. Dennis now buys back the 50 shares he borrowed, which only costs him $1,250. He returns the stock to the brokerage firm where he borrowed them and pockets the difference. He has made a profit of $3,750, less any fees he owes the broker for the initial loan of the shares.