Short selling in brief

Slashing through the BS and putting common personal finance expressions in plain terms.

In the material world, I can only sell things I own: my car, my home, the pair of Jordans that’s been sitting on StockX for 6 months. I can’t, for example, go to Hertz, rent a car, and then sell it, with the promise of returning a similar car in the future. But that’s exactly what short sellers do.

Short selling is what investors do when they want to bet against a stock. It’s the opposite of a long position, in which they bet the value of the stock will go up over time. So how do you make money on a failing company? Take this fictitious example:

Michelle thinks the value of drug company PharmaBrew is overinflated, and that it will soon report that trials of its new productivity pills were a failure. Michelle approaches institutional investor Scoop Capital, which owns PharmaBrew stock—and which believes it will go up—to borrow 1 million of their shares. Scoop Capital agrees, and charges Michelle a monthly fee of $5 million until she returns the shares.

Michelle takes the PharmaBrew shares and immediately sells them for the going rate of $100 each, depositing $100 million in her account. But remember, she’s still on the hook to return 1 million shares to Scoop Capital. If Michelle was right, Scenario A plays out: Within 30 days, PharmaBrew announces the drug trial failure, and its stock falls to $20 per share. Michelle repurchases 1 million shares for $20 million, and returns them to Scoop Capital, minus the fees she owes, and makes just under $80 million.

But here’s the huge risk—Scenario B: Michelle’s hunch was wrong and PharmaBrew announces that its world-changing productivity drug is a success. Its stock price immediately skyrockets to $300 per share. Michelle now has two pretty terrible options: Buy the shares at the new price and take a $200 million loss, or wait it out, hoping the price comes down to a level she can stomach, during which time she’s still paying Scoop Capital $5 million per month. Ouch.

It’s for this reason that only very experienced and very liquid investors should be taking short positions. If you’re long on a stock that you purchased for $100 per share, you can only lose $100 per share. But if you short that stock, your losses can be catastrophic if things don’t go your way.—Daniel