What is Short Stock (pt 2)

If you missed the first post, please read that first. This post will dive into mechanics and risk of short stock. Let's look at mechanics first:

Mechanics of shorting stock:

When you pre-emptively sell a stock, you must borrow it before you can sell it (unlike derivatives which can be created out of thin air). Who do you borrow it from? The broker!

The broker has lots of shares sitting around ready to lend to short-sellers like you. So the broker lends you shares. Like any lending transaction, there is a fee for borrowing. (See our post on bonds) That fee is known as the "borrow." For a bit more info on the stock borrow, see this article.

The fee to borrow shares might be 2% annually, or it could be 60% annually, or anywhere in between. It's a factor of how hard it is for your broker to locate shares.

Example:

You think TSLA is heading lower. You borrow shares from your broker and sell them into the market for $500 per share.

The broker goes looking for shares and has trouble finding them. As a result, the broker charges you 20% APR for the borrow. Hope the trade works quickly!

You are correct, and the next week, TSLA trades to $450. You buy the shares in the market, deliver them back to the broker, and keep the $50 in profit.

Shorting sounds complicated

All of this happens automagically. You push sell, and you push buy, and thus your job is done. All of the borrowing shares and returning them happens in the background without you needing to do anything. It's as simple as selling, then buying back to cover and return the shares.

Risks

Shorting stock gets a bad rap, really. Back in 2008 when the world was ending, it was considered (and marketed) as not patriotic to bet against American companies (which is in stark contrast to the constant message of capitalism hawked by the same sources).

It also has a reputation for being extremely risky. The main reason for this reputation is that a short stock position has unlimited risk, whereas a long stock position has limited risk. 

HOWEVER, let's think about that...

Let's say you buy some Netflix (NFLX). It can go down some $450 per share at this moment. That's a LOT of risk!

It can go up to a million though. That's more risk. Which one is more likely? It could go either way.. we would argue that shorting a stock as a shorter-term trade is perfectly fine and just as risky as taking a long position.

The one thing we will say about shorting stock is that there is one unique risk when shorting stock, and that's the takeover risk.

If a stock has a buyout offer come in, it will often gap up (bad for your position) very hard, causing heavy losses. It can happen to a long position as well, but those would be different scenarios (CEO is arrested, anti-trust suits, etc. etc. etc.). These are collectively known as "black swan" events. Unknown unknowns.

Shorting safely

There is a way to safely short stock with a hard loss limit that cannot be violated. It involves using a stock option. And unlike shorting stock, this can be done inside of retirement accounts, and can be a great way of hedging retirement long-only portfolios.

Since this dips into the more complex topic of hedging, we'd advise being cautious. If you'd like to ask us questions about hedging your portfolio, we'd encourage you to book a free call to chat with us.