I just cannot, for the life of me, understand how you make a profit by it.
In: Economics
Short-selling is just an investment strategy that can be used to profit when the price of something goes down, by selling something when the price is high and buying it back after the price drops.
Imagine you believe that the price of gasoline is going to go down a few days from now, and you want to profit from that information. Today, gasoline is $4/gallon, but you think that in a few days it’ll be $3/gallon.
You know a guy that has a giant tank of gasoline in his back yard. So, you ask him if you can “borrow” 100 gallons of gasoline from him. You even offer to pay him a $10 fee for the privilege of borrowing the gasoline, and you promise to return the gasoline to him in a few days. He agrees to this arrangement and gives you the 100 gallons of gasoline.
Since gasoline is worth $4/gallon today, you now have $400 worth of gasoline. After borrowing that gasoline, you go out on the street and sell that gasoline for $400. You put the $400 under your mattress for now. A few days later, just as you predicted, the price of gasoline drops to $3/gallon. So, you go to a gas station and buy 100 gallons of gasoline for $300. You take this gasoline back to the guy you borrowed it from, and return it to him as promised.
In the end, you sold the gasoline for $400 and then bought it back for $300. You also paid a $10 fee for the privilege of borrowing the gasoline. So, your overall profit was $90.
This is how short selling works, except you’re borrowing/selling/buying stocks instead of gasoline.
If you give me $10 today, I’ll explain what short selling is next week.
Hopefully before then I can find someone who will explain it to me for $5
I am a bank. As a bank I hold 1000 shares of AAPL in my investment portfolio. This is because I want to make money on the stock market. The mechanism? Line go up.
You are a day trader. You want to short sell. You come to me with a proposition. You will take 500 of my shares of AAPL, and return them to me in a month. You will pay be 1$ a share if I do this. This is written into a contract.
The bank loses nothing. There is no risk. They want to buy and hold AAPL. You will make sure they have all 1000 shares in a month, that’s what the contract obliges. In addition, the bank will be gaining 500$ on the transaction, as a fee for loaning the shares.
You, the day trader, want to make money? Right? Well you borrowed from the bank, because you THOUGHT the stock would go down in price. You’re taking a risk based on your own projections.
So how does that function work? Let’s say AAPL is 100$ a share. You anticipate it will decrease to 90$ a share in 2 weeks. What do you do? You take those shares that you borrowed? And you sell em to the highest bidder. You get 50,000$ for this, in cash. Then you wait. In 2 weeks the price drops to 90$. Now you buy the shares back from the market to fullfill your contract. You’ve spent 45,000$ on new shares. You spend 500$ on fees to the bank and walk away with a sum of 4500$ profit. Yay!!!
There is risk. What if the price goes up instead??? Well you sell the shares to the market and it gives 50,000$. Then in 2 weeks the price rises to 110$ a share? Now in order to fullfill your contract you must spend 55,000$ on new shares. That’s 5,000$ of your own money, and now 500$ in fees.
I borrow 10 apples from you because the price of apples is $1 an apple.
I sell your apples for $10.
The price of apples drops to $0.50 per apple.
I buy 10 new apples for $5.
I return to you, 10 apples.
I have made $5 by short selling apples.
You borrow a share of Stupidfad dot com for a month. You sell it for $100. Two weeks later the price falls to $50 and you buy one. At the end of the month you give that share to the lender and you’ve made $50. That’s how you make money short selling.
It’s far easier to lose money short selling because you can misjudge whether a stock will go up or down.
When you buy a share of stock from a broker, the idea is that the broker will take your money and execute a trade with the stock exchange to purchase a share of the stock. Then the broker will posses a share of stock and a ledger that says that the stock belongs to you. When you want to sell the stock, the broker again goes to the stock exchange and executes a trade to sell the stock, and gives you the money (minus their broker fee). That’s the simplest concept of how it works.
But it gets a little more complicated. Sometimes the broker has a pool of stock themselves. So when you go to purchase a share of stock, the broker might sell you the stock “over the counter,” meaning they sell it to you directly themselves from their pool of stock instead of going to the market to execute a trade. Sometimes the broker will make money off of this process. If they bought the stock previously and then it went up by the time you bought it, the broker made money selling it to you for a higher price than they paid. If the broker believes a stock will go up they might do a lot of this (buy a bunch of stock themselves and then sell it over the counter to their customers when it goes up).
And then it gets even more complicated than that. A customer might come to the broker and ask to purchase a share of stock that the broker believes is about to go down. In that case the broker might update the ledger that says that the customer owns a share of the stock before the broker even owns the stock themselves. The idea is that the customer will pay them the current market value for the stock, but the broker will wait a bit before actually buying the stock. If the broker is right, they’ll end up buying the stock for less than the customer paid them, and they’ll get to keep the difference. Selling the stock to the customer before the broker even owns the stock themselves is the original concept of “short selling.” The broker is literally “short,” as in they don’t have enough shares of the stock to cover what they owe their customers.
Since then the concept has been generalized to mean any time that you sell a stock that you don’t own. For regular people that are not brokers, this generally means borrowing some stock and then selling it. The idea being that if the stock price goes down you’ll be able to buy it back for cheaper, pay back the loan and keep the difference.
You borrow stocks from someone. You immediately sell the stocks for personal gain.
Every X days, you pay them money to borrow their stocks.
Whenever you decide to close out your position, aka the stock price has dropped enough, you rebuy at a lower price and give the stocks back to the person you borrowed from.
You pocket the difference.
There are companies that profit from this practice. They publish negative news about a company then short the stock.
To grossly oversimplify, sell stock you dont have and promise to buy it back later. It’s like taking a loan but the amount you need to pay back varies depending on the stock price. If the price goes down, you can pay off your loan for cheap and keep the rest of the initial profits, if the price goes up, you are forced to pay extra and you lose money (and since there’s no limit to how expensive a stock could get, short selling is SUPER dangerous). So while normal stock trades operate on “buy low, sell high” logic, short selling does the opposite “open high, close low”
Naturally, there are a ton of mechanisms in place on most trading sites to prevent people from abusing this. Most commonly, you will be charged interest until you buy back the stock and close the short sale.
You think 1st edition Charizard cards aren’t worth as much as people are buying them for. Your friend has a 1st edition Charizard card, so you ask them to borrow their card and you promise you’ll give them back a 1st edition Charizard card one year from now. Your friend agrees, you give them a small fee to borrow it, and they give you the card. You immediately sell that card for $30,000 since that’s what people are currently buying it for.
Fast forward one year. You no longer have a 1st edition Charizard card, but you promised your friend that you’d give them one back. So now you have to go buy a 1st edition Charizard card that you can give your friend. But the good news is that now people are only buying 1st edition Charizard cards for $20,000. You buy one for $20,000 and give it back to your friend.
By doing this you immediately got $30,000 and then a year later had to spend $20,000, so you’ve gained $10,000 (minus whatever small fee you paid your friend for the right to borrow their card).
Latest Answers