Can you please truly explain like I’m five? Like with bubblegum or cookies as an example? Because I have tried understanding how this works several times and I just do not get it.
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You think that bubblegum will cost less tomorrow, so you borrow some today and sell it at todays prices with the intent of buying some more tomorrow at a lower price to return what you borrowed.
There are often fees involved, meaning that you agree to pay a small amount to the person you borrowed it from. And it can be quite risky as if the price goes up tomorrow rather than down, you still have to buy new bubblegum and return it to the person you borrowed it from.
Shorting a stock is just a catchall for any investment where you *gain* money if the stock *loses* value.
In practice, imagine I’m selling mint bubblegum today for $1 a piece. You hear that next week there will be a new kind of bubblegum released, Cherry flavour. You think, “huh, I bet nobody will want to buy mint bubblegum once Cherry comes out – I bet that mint bubblegum will be cheaper in a week.”
So you come to me and say, “Hey, can I borrow a piece of mint gum? I’ll give you a piece of mint gum back next week!” And I say, “Sure, here’s a piece of the mint gum, but you have to pay me 5 cents to lend it to you.”
So now you have a piece of mint gum that cost you 5 cents, and you owe me a piece of mint gum. You go and sell that gum for $1 (the current going price), so now you have a profit of 95 cents (a dollar less the 5 cents to borrow the gum).
Next week rolls around, Cherry gum is released, and now mint gum is SUPER cheap – say, 25 cents a piece. You still owe me a piece of mint gum, so you buy a piece for 25 cents and give me the gum. Now you have 70 cents (one dollar from selling the gum less 5 cents to borrow the gum and 25 cents to buy the replacement gum), which is a profit you earned *because the price of mint gum went down*. That’s the most simple kind of short sale, but there are other ways to short a stock (namely through futures/derivative contracts, which I can get into if you’d like).
At the simplest, shorting in when you borrow a share of stock from somebody else then sell it. At some point in the future, you need to give the share back to the original person to repay them, so you buy one from somebody else.
You could do this with anything that has many identical copies, like, say, flour. I could borrow a pound of flour from you and sell it to a baker, then, sometime later, buy a pound of flour from somebody else and return it to you. As long as the flour is identical, you don’t know that I sold it.
The goal is that, should the value of the stock go down, you make money. If I sell the share for $100 and can buy the replacement a month later for $90, I made $10 in profit. Naturally, the person I borrow the share from will want payment for the lending, basically interest.
The drawback is that, should the price go up, I lose money, and there is also no limit as to how much money I could lose. If, in the previous example, the stock instead raises to $1000, I lose $900.
Short selling involves borrowing a security whose price you think is going to fall from your brokerage and selling it on the open market. Your plan is to then buy the same stock back later, hopefully for a lower price than you initially sold it for, and pocket the difference after repaying the initial loan.
A new Star Wars movie is coming out. Episode XXV: R2 becomes a Jedi. You know a guy who bought 5,000 toys for Episode XXV, and they’re all new, mint in box. He keeps them in his (crammed full) garage, and he thinks they’ll be worth a buttload of money someday.
You think Episode XXV is going to flop, and flop hard. You go to this guy and ask to borrow those toys. “I’ll return them in six months, exactly as they are. If any are not brand new, mint in box, I’ll replace them with the exact same figure that will be brand new, mint in box.” This guy says okay. But you have to pay him $10,000 to borrow them.
Each of those Episode XXV toys sells for $20 right now. That guy you know paid $20 apiece for them. You think that six months from now, after the movie flops, those things will sell for $2 apiece in the bargain bin. Your friend thinks they will sell out and people will buy them for $100 each on eBay. Your plan is to sell all those toys now, at $20 each, and buy replacements in six months when the price has crashed.
Nobody knows who is right ahead of time. If you are right, then you got $100,000 from selling toys, and you paid $20,000 to buy them back, plus $10,000 for a borrower’s fee. You just made $70,000 profit with very little effort and zero cash up front. And while your friend lost a bunch of money on it, that was his own investment he already made. At least he got a $10,000 fee from you so he didn’t lose quite as much money.
If your friend is right, and the movie is amazing, then you might have to spend a huge amount of money buying all those toys on eBay six months from now. Maybe the R2 with a lightsaber figure is going for $800, and your friend had two thousand of them. There’s really no limit to the amount of money you might lose on this. If things go badly for you.
So you know how you can borrow money from the bank to buy a car or house? You can similarly borrow shares of stock from your investment brokerage, which you then sell. At a later point in time, you buy shares in the stock (hopefully at a lower price) to repay that loan of shares. The difference between what you initially sold for and what you paid to repay the shares is your profit.
Say you want to short XYZ Co. and borrow 100 shares. You sell them at $100, or $10,000 total. 3 months later, the stock has fallen to $80 and you decide to cover your short so you buy 100 shares at $80, or $8,000 total. The $2,000 difference is your profit on the trade.
Literally want a kid example? OK…
Your brother gets a new LEGO set that cost $100 for his birthday in October. You ask if you can borrow it for a month. You return it to the toy store for $100 refund. A few weeks later, Black Friday sales start and you can buy the same LEGO set for $80, so you buy it and return it to your brother. And you have $20 left.
I think bubble gum is going out of style. It was popular because baseball cards used to all have it included. But now no one wants baseball cards anymore, so bubble gum will be less valuable soon. That’s my thought.
I go to a candy store and I promise them no matter what happens, I will buy 100 packs of bubble gum from them in the future, at whatever the going rate is at that time. I will pay them a tiny monthly fee to lend me the gum. And all they have to do is give me the gum now, before I pay. Again, I will 100% need to pay them eventually for the gum. Just not now. They do this because they believe gum will always be valuable, and because I will pay a tiny fee for the privilege.
So now I have 100 packs of gum that I paid nothing for. But eventually I will need to pay for them. When I do pay for them, remember I just need to pay whatever the value of gum is at that time.
So I take my 100 packs of gum and I sell them for 1 dollar each. I have 100 dollars! A month later, just like I thought, less people want gum. In the store and everywhere, gum just costs 50 cents these days. So, I decide now is a good time to pay the candy store. I walk in, pay them 50 cents for each gum I promised to buy. I spent $50 (plus a small fee, so let’s say $52). Now I’m standing there with no gum, and I don’t owe anyone anything anymore. In my pocket is $48 that I didn’t have before.
That’s the basic idea. I started with no money, just a promise. Then I borrowed something, sold it, then waited until the value was lower, and paid back my loan.
Note that if the value of gum went up and up and up and up, eventually I would end up losing money (because ongoing small fee to delay the payment). Eventually I would need to buy back the gum at let’s say $200, plus the fees I had already paid. So that’s where the risk comes.
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