What Is Shortselling — And Is It Evil?

Mon, May 31, 2010

Financial Advice, Investment

The media, along with politicians, love to lambaste shortsellers and claim that they are the culprits behind stock market declines. When you sell short a stock you are betting that it will go down. Logistically, you “borrow” shares of the stock with a future promise to return them, and then you sell those shares on the open market. Assume ABC stock is trading at $20, and your research leads you to believe that it will soon drop. You decide to short 1000 shares of ABC which means you are borrowing those shares from another party. You then sell those 1000 shares on the open market for $20 per share yielding you $20,000 in cash. Assume you were correct in your thesis and ABC drops to $15 per share. You decide to close your position and buy 1000 shares on the open market for $15,000. You then use these 1000 shares to return them to the party from whom they were borrowed — which closes the transaction netting you $5000 profit. Alternatively, assume you were wrong and ABC went up to $25 as opposed to dropping. You then have to purchase the 1000 shares needed to “cover your short” for $25,000 thus resulting in a $5000 loss. When you are short a stock you profit when it goes down and you lose when it goes up.

Many feel that betting against the success of a stock is unpatriotic, rude and downright evil. These feelings are highly misguided. Shortsellers are needed in order to make a market. Those who seek to buy shares of ABC as an investment need someone to sell them these shares. Shortsellers are often the only ones on the other side of the transaction, and without them the market would suffer great decreases in liquidity. Furthermore, short sellers are often the first to sound the alarm when it comes to corporate fraud — or plain old bad business plans. They provide for a great check against corporate CEO’s who are prone to be overly optimistic and view the future solely through rose colored glasses. If you think a stock will decline, then do not be dissuaded from shorting it because of questions of ethics or morality. Shorting is a legitimate market strategy that virtually all shrewd investors must employ at one time or another.

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