Island Investing: Shorting

My article in today’s Keys Weekly:

Q. What does it mean to “short” a stock?

A. Buying stock in anticipation of it going up, the way most people traditionally think about investing, is considered “going long.” Shorting is a way to profit from the decline in a stock’s price. Here’s an example.

For several years, Captain Jack noticed an increasing number of passengers wearing brightly-colored, odd-looking shoes called Gatorz. A few weeks ago, Jack noticed a sudden decline in the number of tourists wearing the shoes. He thinks the fad has finally passed, and as a result he expects the company’s stock price to fall.

Jack calls his brokerage and tells them he wants to short ten shares of Gatorz (ticker: CLOG). The brokerage then “borrows” those ten shares, typically from another investor who owns them, and immediately sells them into the market at the current price, in this case, $20. The proceeds from the sale, totaling $200, are then deposited as cash in Jack’s brokerage account.

A week later, Gatorz reports its quarterly earnings and, sure enough, sales of its footwear have completely tanked. The stock falls from $20 to $5. Jack “covers” his short by buying shares on the open market to replace the ones he borrowed from his brokerage. Because Jack shorted CLOG at $20 and covered when it fell to $5, he made $15 per share, or $150 total.

Shorting is similar to asking your brokerage for a loan – only the loan is made in stock, not dollars. When done as part of a traditional long portfolio, shorting can help you profit from both rising and falling stocks. Shorting also comes with some risks, however.

Because a stock’s price can theoretically rise forever, your losses from shorting could be unlimited. Being short also means you’re fighting the general long-term trend of the market, not to mention the effort of a company’s management team. In addition, if the stock you shorted pays dividends, you’ll be required to pay them. For those reasons, shorting is usually better left for professional investors.

Next week I’ll discuss naked shorting. You know you can’t wait.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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