What is a stock anyway?

In order to understand a short position in a stock, we must understand what a stock is. So what is a stock?

A stock is a small piece of a company. The holder is entitled to whatever that company pays out to its owners. Those payouts are called dividends. It's worth pointing out that most people don't buy stock to get the dividend. They buy stock because they think they are going to be able to sell that same stock to someone else for more money than they bought it.

People buy stock largely to speculate.

Going Long

When we buy stock, we say we are "going long." What does that mean?

First of all, it doesn't mean we are planning to hold the stock for a long time. Going "long" or "short" has nothing to do with how long we will hold a position.

It means we have bought the stock hoping for it to appreciate. We want it to go UP.

Just like buying a house (or most other investment transaction), we pay money up front for something and hope that it's worth more later.

Almost all of the money in the market is "long" the market. Most of the money in the market wants it to go up.

Being/going long is also called being/trading bullish.

Going Short

When we reverse the ORDER of our buy and sell tactic, we are said to be going short.

We sell the stock first, then hope to buy it back later for less money than we initially sold it for.

We'll talk about mechanics in a moment, but first, an example:

Say you order a custom couch. It doesn't exist yet, because it's custom, and has to made from scratch to your very exacting specifications.

The company takes your money, and THEN makes your couch. The company has gone short one couch. They sold you a couch they didn't own, then completed the transaction by delivering a couch to you for a profit. They shorted 1 couch.

The Mechanics

No, this section isn't about a group of Pep Boys who trade on the side. This is the section where we explain what actually happens when you "go short."

We decide to get short on, let's say, Adobe. Our thesis is that Adobe is richly valued and will be trading lower sometime in the near future. We are betting on a move lower, therefore we are bearish and we are taking a short position in the stock.

The Sell-to-Open

So what do we do? We sell shares of Adobe!

WAIT!

We don't actually own the shares. So we borrow them from our broker, who, it just so happens, has 400,000 shares available to lend out. More on that in a moment.

We borrow the shares from our broker, and we sell them in the market. We collect a juicy credit for those very expensive Adobe shares we just sold. Can we take the money and run??

No. You are obligated to deliver the shares that you borrowed back to your broker at some point in the future. How do you deliver them to your broker when you don't own them?

The Buy-to-Close

You buy them.

You're either going to buy them at a lower rate than what you sold them for initially, which gives you a profit (sell high, buy low) or you're going to buy them back higher than what you sold them for (sell low, buy high) and take a loss.

That paragraph may take a few reads to sink in. That's ok. Read it a few times. We'll wait.

As a final point here, you, the trader/investor is only responsible for pushing the "sell" and "buy" button. All the borrowing and returning is done automatically behind the scenes. No sending of certificates in the mail or hand delivering them to your local Schwab office.

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Next Up...

We're going to dive into the different risks involved in shorting a stock, and we'll go through some real-world examples, and even throw some charts in there! Check out part 2 for more on shorting stock.