This post originally comes from BrainFeed.co.
Why do investors buy a company’s stock? There can be many reasons, but they always boil down to one assumption: The stock will be worth more in the future than it is worth today. But what if you are convinced the stock will be worth less tomorrow than it is worth today?
If you think a stock is “overvalued” and you want to profit from this conviction, it may be time to get short. If you think a stock is “undervalued”, you would want to buy the stock — this is called being “long”. So, if you have the opposite opinion, you would take the opposite action: sell the stock. It’s easy enough to buy something you don’t own. But how do you sell something you don’t own?
To get short, the first step is to borrow the stock in question from someone who does own it. Like when you borrow money, you will pay interest on the borrowed stock. Step Two is to sell the borrowed stock. Finally, Step Three is to repurchase the stock at some point in the future so you can return what you borrowed. Hopefully, when you repurchase the stock, it will have dropped to a lower price. Then, you can pocket the difference between what you sold the stock for and what you repurchase the stock for, less any interest incurred.
A Risky Bet
“Shorting” a stock is far more risky than buying a stock. When you buy a stock, the maximum amount you can lose is the amount you invested, if the stock drops to zero. But a stock can also rise very quickly… If you bet that you will be able to repurchase the stock at a lower price, but it increases instead, you still have to buy the stock at a higher price to return what you borrowed.
Let’s look at a simple example. Let’s say Alice loves a theoretical stock called Tezlah, and John thinks Tezlah is overvalued. Tezlah trades at $100. Alice buys one share, while John shorts one share.
- In Scenario A, Tezlah drops to $0: Alice loses $100, John gains $100 (less interest).
- In Scenario B, Tezlah rises to $500: Alice gains $400, John loses $400 (plus interest).
As is clear, “shorts” like John can quickly get burned and lose a lot of money. Especially when millions of dollars are in play…
Investors must always examine a stock closely before investing. But when going short, this is even more important. Stocks can go up longer than expected, and losses from a short are hypothetically unlimited. (If a stock goes up forever, that is… RIP Tesla shorts.)
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