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jv22222

It’s been explained to me a number of times but I still don’t get it.

How does a short actually work?

The part I don’t get is, how do you actually get out of the position and make the money?

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Borrow a stock worth $100, sell it, collect $100 cash.

Buy stock back at a later date for $50 (You thought the price was going to go down right?), give it back to the original lender.

You have now made $50.

This is my (basic/primitive) understanding of shorting

Thanks!

One question: Who do you borrow the stock from? Why do they agree to lend it?

Forgive the oversimplification, but you borrow from someone who owns the stock. They lend it because they collect fees/interest when you borrow it.

You pay the person you borrow the stock from a fee.

I believe you pay them some small sum for it, so you could call it ‘renting’ the stocks for a short while.

Why does somebody else get paid to rent my stocks? Can this be avoided?

Usually people don't go to an exchange directly to buy stocks, they go to a broker-dealer: that's who lends the stock out to short.

Fees to short certain stocks can be quite high, so even if the stock dips it's possible to lose money.

Generally it's from brokers who are holding it on account, and they agree to lend it for a fee and some collateral.

There may be problems finding someone to lend thinly traded stock. Or you can take out a short position and not be able to buy it back at sensible prices: this results in a "short squeeze". https://www.reuters.com/article/us-volkswagen/short-sellers-...

It is possible to lose more money than you invest with short selling, so be careful.

In addition to the sibling answers about collecting interest and brokers, lending stock to short sellers is a good thing if you are a long-term investor. Shorts put some downward pressure on the price and give you an opportunity to buy more at a reduced cost. Additionally, if your thesis on the company being good is true, those shorts are eventually going to be buying back the stock after it has appreciated, ultimately creating even more upward price pressure in the long-term.

Fun fact: a lot of ETFs and index funds generate revenue on the backend by lending out the stocks they hold and charging a bit of interest to the borrower.

I wondered this after watching The Big Short. Here's how I understand it:

- Alice estimates that the price of Asset is going to drop from $200 to $100 in one week

- Alice borrows some quantity of Asset from Bob

- Alice sells Asset to Charlie at $190

- After one week, Alice buys Asset from Dave at $100 and returns it to Bob

That is how you short a publicly traded stock. The mechanics of the shorting in the Big Short is actually a lot different. It is done with credit default swaps which you can basically think of as an insurance policy. The difference is that it is on a financial asset instead of on a physical asset and you also don't need to actually own the asset you are insuring. Like buying insurance on a car you don't own (you can't actually do this). Pay the premiums and if the car crashes you get the value of the car in cash.

The idea is that you sell stock you don't have, buying them back later, hopefully at a lower price in order to make profit.

The tricky part, at least for me, is how it works in practice. You can't own a negative number of stocks, it means that what you are selling doesn't come from nowhere, and because it is finance, the people who make the short possible have to work for personal gain.

The key here is that there are 3 actors:

A a buyer. Nothing special about him: he buys the stock, and sell it at a later date. He expects the value to go up and make a profit by selling at a higher price.

B is a shorter, he borrows stock (with interest) and sell them to A and buy them back at a later date to repay his debt. If the price went down he will buy back for cheaper than he initially payed, making a profit.

C is a lender, he owns stock and lends them to B. He makes profit on interest rates.

So the stocks go C -> B -> A -> B -> C and it all cancels out in the end. As for cash, C always wins, just like the house in a poker game, while the evolution of the stock determines how money changes hand between A and B.

In reality there are more than 3 actors, and there are mechanisms in place to limit the risk of bankruptcy, but that's the general idea.

Borrow shares, sell them, buy them back later (at a lower price, if all goes well), then return them.

How can you buy them back? What if the person you sold them to doesn’t want to sell?

Buy any instance of that share back, not that exact one.

And if no one wants to sell it, the price has gone up...meaning your bet was wrong and you lose money

What's the motivation of sharedholders to lend shares?

They are paid, of course.

You get paid for providing the shares.

So if I had one million shares and thought the stock was going to go up, I could make some extra cash by lending it to people and making them pay me for the right.

The borrower pays interest to the lender.

Let's say you're a manager at an index tracking pension fund. You're likely to be holding shares in the index at a proportion similar to the index weightings. And you're likely to hold most of them for the long term as you're required to track the index.

The key phrase is long term. It doesn't really matter to you whether or not a particular share price goes up or down in the short term as you aren't interested in selling.

So what you can do is lend the stock to a shorter. You enter into a contract where you give them X shares of a stock and they're obliged to give you X shares back in a few days regardless of any price move. They're also obliged to pay a fee for the service.

The net effect is that, instead of having X shares, you now have X shares and the fee.

The major risk for you is that they don't give you the shares back. That's why these contracts usually have collateral agreements such that, if they renege, you haven't lost out by much.

With currencies there are no shares so the mechanics are quite different. Currencies come in pairs so you don't just short the pound, instead you bet that the euro will increase in value relative to the pound. So in this case you are long the euro and short the pound.

https://en.wikipedia.org/wiki/Currency_pair

Think of short as a negative share position. To close it out, buy the shares in the market at the (hopefully lower) price. You've (1) sold at a higher price and (2) bot at a lower price - profit is the difference.

Mechanically, the negative share position is achieved by borrowing shares to sell. This carries an obligation to give 'back' the borrowed shares, which is satisfied when you buy in the market.

Shorting major currencies is easier than shorting stocks. It's done fairly easily on the futures market, where you create a contract (effectively with the exchange) that says you agree to deliver a certain number of pounds at a predetermined point in the future in exchange for a certain number of dollars today. If the pound falls relative to the dollar, you make a profit.

A timely video from Barrons:

https://twitter.com/barronsonline/status/1070391112475557889

Equity example, you borrow shares from your broker, sell them, and later buy them back to return the shares you borrowed. You make money if the price is lower when you cover your short (excluding whatever fees)

you borrow the stock, sell it, then buy it back when (hopefully) the price went down and return it to the borrower. You pocket the difference minus a borrowing fee.

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