What is a “Short”
A Short Sell or Shorting of a stock is a mechanism by which an investor makes money if a stock drops in value. How is such a counterintuitive thing possible? It is explained below.
Typically people make money off stocks by buying them, hoping they’ll increase in value and benefiting from the increase in net worth. Or they sell when it is high priced and pocket the difference in value. Sometimes investors carry out Leveraged Buys in which they borrow money from a bank or authorized brokerage lender, use that borrowed cash to buy stock, wait for the loan’s term hoping that the stock will rise in value, sell, use the money from the sale to pay back the loan plus interest and then pocket the difference between the share’s price and the loan plus interest amount. This way, the investor doesn’t have to risk his own money but still earns a profit.
And typically when a stock’s price falls, people lose money. Investors who paid their own money for the stock when it was higher priced, now have nothing to show for it. Investors who used Leveraged Buys are now saddled with debt and nothing of value in return for that debt. So, when a stock price starts to fall, investors immediately try to sell it back to the originating brokerages to minimize their losses. This is often a reactive measure as this sell off occurs only after a dip in the stock’s price.
But someone who anticipates that a stock will drop in value can use a special version of a leveraged buy to profit from the price drop.
An investor can lease a stock to an authorized brokerage lender. Similar to leasing a car, the terms are that you hold on to the stock for sometime, after which you must buy it. The lender gives the investor money equivalent to the current value of the stock when buying, which the investor must use to buy the stock at its full price when the lease term expires. If the stock doesn’t change value, the investor pays the lender the exact amount he borrowed and gets full ownership of the stock. No money is gained, or lost. If the stock rises in value, the investor must now pay that higher price of that stock.
But if the stock falls in value, the investor buys the stock at the lower price. And he makes a profit because the money he was lent in the beginning was higher than the stock’s current value. He only needs to use a portion of that money to buy that stock. The rest of it, he pockets.
