Published On: Tue, Jan 28th, 2014

Shorting Shares

An investor will usually look for stocks to buy in the hope that they will increase in value over time. He is in it for the long-term, and doesn’t invest expecting to close out his trade anytime soon. Of course the investor will keep an eye on how his stocks are doing, but he will wait until there’s a reason to sell.

What the investor does is very easy to understand. But if you were to only do this, then you would have to wait for share prices to rise before you can make any money. Okay in the long-term with an expanding economy, and this describes the environment that it is ideal to invest in.

This doesn’t particularly suit the short-term trader. As I mentioned before, the short-term trader wants to trade frequently, whether it is hourly, daily, or weekly, and does not want to wait for months for the market to go up. The trader wants to anticipate supply and demand changes, and get in and out at the right time to make money. Technical analysis should show when the price is likely to move more quickly.

With that said, if the short-term trader only makes money when the prices go up, then he is only profiting from half the moves that there are on the stock market. Fluctuating prices, by definition, go up and down all the time, and if he can anticipate when a price is going to fall, then he wants to make money from that direction too.

This is where shorting shares comes in. If you know how and are confident to “short” shares, then you can make money from a fall in price. It is something that you should learn about and not be scared to put into practice, when needed.

Many people don’t like the idea of “going short”, when they first see it. It is another aspect of trading that can seem wrong at first sight. It’s very easy to understand how you can buy something and sell it later at a higher price to make a profit, but not so easy to see how you can express an interest in something in some way (called shorting), and make a profit when it later falls in price.

When you buy shares in the normal way you are said to go “long” on them. And, naturally, you do the opposite when you want to profit from a fall in value, so you “short” them. Let’s face it, if you haven’t bought them already, then you are short of them, so the language is not so strange. Shorting shares is not a black art, but a widely used tool in the trader’s arsenal. If you feel confident in doing it, then you have opened up a whole new world of opportunity.

Before I go into the detailed explanation, let it be said that your broker will sort all the following out for you, and you simply have to make the trade, trusting that it works. But you probably want to understand how on earth it could work, particularly if you’re going to be relying on this system for half your trading income.

Simply put, when you “short” a stock, you declare that you want to borrow some of that stock from somebody (anybody) and sell it. If all goes according to plan and the price falls, then later on you can buy the same amount of stock back for less money and return it to whoever owned it in the first place. The person that you borrowed the stock from doesn’t even need to know that anything happened at all. You pay less to buy the stock in the future than you received when you sold it, therefore you have a gain. The person you borrowed the stock from is “whole” again, back in the same position as they were before the transaction. That is how you make money from shorting a stock.

That’s the simple principle. There are a couple of wrinkles that you should probably know about. First, it’s possible that the original owner of the stocks wants to do something with them, perhaps even sell them, while you have them “on loan” and are holding a short position. The broker is responsible for finding the stocks that he borrows on your behalf in the first place, and he has to make sure that the original owner is not inconvenienced and remains unaware that his stocks were used for anything.

So what is the broker to do if the original stock owner wants them back? Usually, he will look around and find someone else whom he can borrow the stocks from, and just switch it over. The original owner has the stocks that he expects and can do what he wants; the second owner whose stocks you are borrowing now doesn’t even know that, and the broker keeps a tally and makes sure there are no problems.

It doesn’t often happen, but it could be that the broker can’t find someone else to borrow the shares from. If so, he will have to demand that you replace the original shares by buying them right away, regardless of whether the price has gone up or down. The code of honour that allows him to use shares for shorting requires that he takes that action.

It is worth saying that I have never had this problem, and modern technology makes it even less likely. But it is a warning that has to be made.

Another wrinkle is again from the principle that the original owner is not affected in any way by your trading. This one is a real concern. If the company pays a dividend while you are shorting the shares, as you sold them the owner obviously will not get the dividend payout from the company that he is expecting. The original owner is entitled to the dividend, he has done nothing to harm his own position and rightly expects the money.

It is your “fault” that the shares are not around, and therefore the company will not pay a dividend on them. This means that you have to pony up the money in the amount of the dividend expected. Your broker, a busy man, will take care of this and take the money out of your account to pay to the original owner. The original owner must be kept “whole”, that is the principle by which the system works.

As I stated earlier on, these are details and they will be taken care of by your broker. You should not allow them to overly concern you, and if you are interested in trading for profit, you must learn to become comfortable taking out short positions as well as long positions.

As an aside, you will quite possibly find that you can make a quicker profit from going short than from going long and simply buying shares. This is because share prices, when going up, appear to grow steadily rather than going up in leaps and bounds. On the other hand, when a share price drops it often does so more quickly. Once investors see the price falling, they rush to sell before they lose anymore, making the price plummet. This means it is even more important that you become at ease with taking out short positions.

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