Friday, May 27, 2011

The Short Sale

Okay, so the stock market might not be as random as this cartoon, but it does show that sometimes the market moves irrationally.  Again, I would like to reemphasize holding stocks for the long-term since most of the short-term fluctuations in price are unpredictable.  You will definitely experience a lot more volatility the first few months after purchasing a stock than when you look at time horizons of several years.

We went over last time that you can make money off the dividends and the capital appreciation of the stock.  Of course, this assumes you are purchasing a stock outright.  There are ways to make money when stocks fall as well.  I wouldn't recommend this method because of a few reasons, but it is a tool every investor should be aware of.  First of all, let's start with the basic proposition for how to make money on the change in price of stocks.

The basic proposition is to buy low and sell high.  This should be fairly intuitive for everyone out there: when you buy something, you want to make sure that you are paying less than whatever you are purchasing is worth and when you sell it, you want to try to get as much money as possible from the buyer.  This is where buy low sell high comes from.  Of course, in a declining economy (known as a bear market) where stocks continually decrease, it may seem silly to buy stocks as prices fall.  How should you make money in this situation?

There is something called a short sale of stock.  Essentially when you buy a stock in the anticipation of it going up, you buy low now and then sell high later.  However, if you don't think a stock will do particularly well, you can perform a short sale and sell high now and buy low later.  A short sale is when you sell a stock you don't own by borrowing shares from your broker (the agent through which you make your investment transactions) and selling them to someone else.  Now you owe your broker those same shares, so later (when the price drops hopefully), you buy your shares back from someone in the market and give them back to the buyer.  Let's go through an example.

Let's say that today, you are looking at shares of Microsoft (ticker MSFT) and you believe the price will go down over the course of the next year (we'll look more at what you should look at in a stock to determine whether it will likely go up or down).  Right now, they are trading at $25 and let's say you want to trade $1000 worth of stock.  So you go to your broker (or go online) and sell short 40 shares of Microsoft ($1000/$25 = 40).  You receive $1000 (not including commissions but we will look at those later on) for your short sale which you can invest in other securities.  Let's say a year passes and Microsoft has had a very bad year.  The price is now $20 a share.  You decide you want to exit your position so you buy back (called buy to cover) the 40 shares of stock you owe for a total of $800 (40 shares * $20 = 800).  So you got $1000 from the short sale and then you buy to cover for $800, keeping the $200 difference and making a nice 20% profit on your decision.  Of course, if you were wrong and the price went up to $30 per share, you would lose 20%.  

There are also some technical details specific to short selling that I won't go into, but that is the basic idea behind the mechanics.  Generally, when you sell short a stock, you are looking at most within the 1-2 year range.  It is also known as going short on a stock (as opposed to going long which is when you buy the stock).  These short-term trades are exposed to the short-term volatility which is why I would not recommend it to most students and investors.  If you think a stock price is going to go down, buy the stock of its competitors or stay away from that stock.

Another thing to think about is that when you buy a stock, your risk is limited to the amount of money you paid for the stock (because the stock price can't go below $0).  With a short sale, the amount you can lose is infinite since the stock could potentially shoot up in price to infinity (albeit that is extremely unlikely).  Also, while you have a stock short-sold, you would also have to pay out dividends that the company pays out since you are only borrowing the stock.  In any case, I will be focusing more on how to pick which stocks to purchase and mostly talk about buying stock instead of short selling.  It is a good tool to be familiar with, though, and hopefully this post has given a good basic understanding of the method.

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