21st Century Economics

The Short and Simple Explanation:

You pay a fee for the “option” to buy stock at a future price so you can sell it now. In other words, you have the option to sell some stock now at a high price and then, at some time in the future, you buy it when the stock price has dropped.

The real neat trick is that you can wait until that future time to see if the price did, in fact, rise before you elect to sell the stock at today’s price. If the stock does not rise, you simple elect not to complete the transaction and all you forfeit is the cost of the option.

Typically, you buy the option and then wait to confirm that it is going to go down. If it begins, then you can elect to exercise your option and sell now at its current price of let’s say $110. Suppose you sell 100 shares for a total income of $11,000. Now you wait for the stock price to drop. When it reaches $85 per share, you buy 100 shares for $8,500. You sold the stock for $11,000 and bought it for $8,500. You made $2,500 minus the cost of the option.

Typically, the usual option buyer would buy much more than 100 shares. You can see that if you bought 10,000 shares, you would have made $250,000. The advantage is that you bought the 10,000 shares with money you made from the sale of the 10,000 shares. Sounds weird but it’s done everyday on Wall Street. You also have a low risk since if the stock goes up or does not change, you can elect to NOT exercise your option. You lose the fee you paid for the option but that’s all you are out of pocket.

Where this is most useful is when you KNOW that the stock will move down. In the case of a known political, economic or Middle East crisis, we often do KNOW that some stocks will go down and some will go up and then down. Therein lies your chance for profit.

You should read this next section but you can also skip down to the section marked Cautions.

The Longer Explanation:

As you might expect, it’s a little more complicated than what is listed above. Here’s how it really works.

You tell your broker you want to short 100 shares of ABC, Inc. at $110. This means that you are entering into an agreement with the broker to temporarily borrow 100 shares of this stock at $110/share for specified period of time. Technically, you are borrowing the 100 shares from your broker in order to sell them to someone else at the current price of $110.

The broker either has the shares in inventory or he borrowed them from a client or another brokerage firm. The sale is made and the shares are now in the hands of a third party that has paid $110 per share for them. At this point, you have not paid the broker any money but you do owe him for the 100 shares.

Now you wait. If the price of ABC, Inc. goes down, to $85, you then buy 100 shares of the stock at that price. You have now spent $8,500 for the 100 shares of stock. You now return to your broker the 100 shares of ABC, Inc. stock that you borrowed. You borrowed the stock at $110 and sold it at that price for $11,000. Then, later, you bought it back at $85. You made $25 per share in profit or $2,500. You sold the borrowed stock for $11,000 and bought it back for $8,500. Technically, you sold something before you owned it and bought it back after you sold it. Sounds crazy but that is what is called Selling Short.

Under some circumstances, it is possible to return the stock to the broker before you have to pay to buy it meaning that it is a paperwork drill until he sends you your $2,500 profit.

Cautions:

As with all stock transactions, there is a down side to this activity. Suppose the price of ABC, Inc. goes up to $125. You borrowed it from the broker and sold it at $110. Now he wants his stock back but the price has gone up. You now have to go into the market and buy 100 shares of ABC, Inc. at $125 per share or $12,500. You can then return the loaned stock to the broker. In this case, you lost $1,250.

There are ways to protect yourself from too much of a rise in price by using a ‘buy stop’ order GTC (Good Till Canceled). You decide that if the price of ABC, Inc. rises $5 you want to get out of the deal. You would place a buy stop order at $115. Then, if the price of ABC, Inc. rises to $115, you are assured that you will get out at about $115.

You may also want to get out of a short trade when you have hit a certain amount of profit. In this case, you would use a buy stop at you maximum loss level and a buy stop at your profit target level. This is called an either/or order. You are placing two orders to protect you if the stock rises and to take profit if the stock declines.

For the most part, brokerage firms do not place a time limit on the shares of stock they loan. This is because they make a commission both ways. And also, they want to keep the customer happy. There are some other rules and limits on this kind of sale but it has its rewards.

As you will see, selling short is a very useful technique when you know a stock or other investment will go down. What do you think will happen to all those defense contracting companies after this Iraq crisis all dies down? What do you think will happen to those defense contracts - like with Haliburton, if an anti-war president is put into power in 2009? What do you think will happen to GOLD after the panic passes about an oil crisis or a war with Iran? You can bet money that they will go down from their Bush Era highs. Make Money!